These 4 Measures Indicate That China Shenhua Energy (HKG:1088) Is Using Debt Reasonably Well

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that China Shenhua Energy Company Limited (HKG:1088) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for China Shenhua Energy

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, it does have CN¥132.9b in cash offsetting this, leading to net cash of CN¥70.6b.

A Look At China Shenhua Energy's Liabilities

According to the last reported balance sheet, China Shenhua Energy had liabilities of CN¥72.8b due within 12 months, and liabilities of CN¥65.0b due beyond 12 months. On the other hand, it had cash of CN¥132.9b and CN¥12.6b worth of receivables due within a year. So it actually has 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. The balance sheet is clearly the area to focus on when you are analysing debt. 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're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. 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. Over the last three years, China Shenhua Energy recorded free cash flow worth a fulsome 86% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

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¥70.6b, as well as more liquid assets than liabilities. And it impressed us with free cash flow of CN¥59b, being 86% of its EBIT. 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. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 1 warning sign for China Shenhua Energy that you should be aware of before investing here.

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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