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

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.' 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 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?

What Risk Does Debt Bring?

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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for China Shenhua Energy

How Much Debt Does China Shenhua Energy Carry?

The image below, which you can click on for greater detail, shows that China Shenhua Energy had debt of CN¥52.7b at the end of March 2023, a reduction from CN¥60.9b over a year. But on the other hand it also has CN¥178.1b in cash, leading to a CN¥125.4b net cash position.

A Look At China Shenhua Energy's Liabilities

The latest balance sheet data shows that China Shenhua Energy had liabilities of CN¥95.9b due within a year, and liabilities of CN¥64.6b falling due after that. Offsetting this, it had CN¥178.1b in cash and CN¥15.9b in receivables that were due within 12 months. So it actually has CN¥33.6b 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. Succinctly put, China Shenhua Energy boasts net cash, so it's fair to say it does not have a heavy debt load!

The good news is that China Shenhua Energy has increased its EBIT by 9.5% over twelve months, which should ease any concerns about debt repayment. When analysing debt levels, the balance sheet is the obvious place to start. 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.

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. Over the last three years, China Shenhua Energy recorded free cash flow worth a fulsome 81% 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 it is always sensible to investigate a company's debt, in this case China Shenhua Energy has CN¥125.4b in net cash and a decent-looking balance sheet. The cherry on top was that in converted 81% of that EBIT to free cash flow, bringing in CN¥79b. So is China Shenhua Energy's debt a risk? It doesn't seem so to us. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 2 warning signs for China Shenhua Energy (1 can't be ignored) you should be aware of.

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.