Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, China Shenhua Energy Company Limited (HKG:1088) does carry debt. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is China Shenhua Energy's Debt?
You can click the graphic below for the historical numbers, but it shows that as of September 2020 China Shenhua Energy had CN¥62.3b of debt, an increase on CN¥50.8b, over one year. However, its balance sheet shows it holds CN¥132.9b in cash, so it actually has CN¥70.6b net cash.
A Look At China Shenhua Energy's Liabilities
We can see from the most recent balance sheet that China Shenhua Energy had liabilities of CN¥72.8b falling due within a year, and liabilities of CN¥65.0b due beyond that. On the other hand, it had cash of CN¥132.9b and CN¥12.6b worth of receivables due within a year. So it can boast CN¥7.67b more liquid assets than total liabilities.
This surplus suggests that China Shenhua Energy has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that China Shenhua Energy has more cash than debt is arguably a good indication that it can manage its debt safely.
But the bad news is that China Shenhua Energy has seen its EBIT plunge 15% in the last twelve months. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if China Shenhua Energy can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. China Shenhua Energy may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last three years, China Shenhua Energy generated free cash flow amounting to a very robust 86% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.
While it is always sensible to investigate a company's debt, in this case China Shenhua Energy has CN¥70.6b in net cash and a decent-looking balance sheet. The cherry on top was that in converted 86% of that EBIT to free cash flow, bringing in CN¥59b. So we are not troubled with China Shenhua Energy's debt use. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Like risks, for instance. Every company has them, and we've spotted 2 warning signs for China Shenhua Energy (of which 1 is significant!) you should know about.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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