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

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. As with many other companies China Shenhua Energy Company Limited (HKG:1088) makes use of debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. 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.

View 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 China Shenhua Energy had CN¥48.5b of debt in June 2023, down from CN¥60.2b, one year before. However, it does have CN¥183.9b in cash offsetting this, leading to net cash of CN¥135.4b.

How Strong 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¥141.2b due within 12 months and liabilities of CN¥69.5b due beyond that. Offsetting these obligations, it had cash of CN¥183.9b as well as receivables valued at CN¥22.6b due within 12 months. So these liquid assets roughly match the 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 while it's hard to imagine that the CN¥585.0b company is struggling for cash, we still think it's worth monitoring its balance sheet. While it does have liabilities worth noting, China Shenhua Energy also has more cash than debt, so we're pretty confident it can manage its debt safely.

China Shenhua Energy's EBIT was pretty flat over the last year, but that shouldn't be an issue given the it doesn't have a lot of debt. 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 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 cold hard cash means it can reduce its debt when it wants to.

Summing Up

We could understand if investors are concerned about China Shenhua Energy's liabilities, but we can be reassured by the fact it has has net cash of CN¥135.4b. And it impressed us with free cash flow of CN¥66b, being 76% of its EBIT. So we don't think China Shenhua Energy's use of debt is risky. 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. We've identified 2 warning signs with China Shenhua Energy (at least 1 which doesn't sit too well with us) , and understanding them should be part of your investment process.

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.