Is China Shenhua Energy (HKG:1088) A Risky Investment?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that China Shenhua Energy Company Limited (HKG:1088) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

View 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¥35.9b at the end of September 2024, a reduction from CN¥38.8b over a year. However, its balance sheet shows it holds CN¥154.2b in cash, so it actually has CN¥118.3b net cash.

How Healthy Is China Shenhua Energy's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that China Shenhua Energy had liabilities of CN¥95.9b due within 12 months and liabilities of CN¥60.6b due beyond that. Offsetting this, it had CN¥154.2b in cash and CN¥18.3b in receivables that were due within 12 months. So it actually has CN¥16.0b more liquid assets than total liabilities.

This short term liquidity is a sign that China Shenhua Energy could probably pay off its debt with ease, as its balance sheet is far from stretched. 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.

While China Shenhua Energy doesn't seem to have gained much on the EBIT line, at least earnings remain stable for now. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if China Shenhua Energy can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

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 produced sturdy free cash flow equating to 77% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that China Shenhua Energy has net cash of CN¥118.3b, as well as more liquid assets than liabilities. And it impressed us with free cash flow of CN¥66b, being 77% of its EBIT. So we don't think China Shenhua Energy's use of debt is risky. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 2 warning signs for China Shenhua Energy (1 is a bit unpleasant!) that you should be aware of before investing here.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.