China Shenhua Energy (HKG:1088) Has A Pretty Healthy Balance Sheet

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that China Shenhua Energy Company Limited (HKG:1088) does use debt in its business. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for China Shenhua Energy

What Is China Shenhua Energy's Debt?

The image below, which you can click on for greater detail, shows that China Shenhua Energy had debt of CN¥38.8b at the end of September 2023, a reduction from CN¥59.6b over a year. But on the other hand it also has CN¥139.6b in cash, leading to a CN¥100.9b net cash position.

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¥94.4b falling due within a year, and liabilities of CN¥60.0b due beyond that. Offsetting these obligations, it had cash of CN¥139.6b as well as receivables valued at CN¥20.1b due within 12 months. So it actually has CN¥5.28b more liquid assets than total liabilities.

This state of affairs indicates that China Shenhua Energy's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So it's very unlikely that the CN¥731.0b company is short on cash, but still worth keeping an eye on the balance sheet. 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 11% in the last twelve months. If that rate of decline in earnings continues, the company could find itself in a tight spot. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine China Shenhua Energy's ability to maintain a healthy balance sheet going forward. 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. While China Shenhua Energy has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. During the last three years, China Shenhua Energy produced sturdy free cash flow equating to 76% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Summing Up

While it is always sensible to investigate a company's debt, in this case China Shenhua Energy has CN¥100.9b in net cash and a decent-looking balance sheet. The cherry on top was that in converted 76% of that EBIT to free cash flow, bringing in CN¥58b. So we don't think China Shenhua Energy's use of debt is risky. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for China Shenhua Energy (of which 1 is significant!) you should know about.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.