We Think Yankuang Energy Group (HKG:1171) Can Stay On Top Of Its Debt

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.' 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 Yankuang Energy Group Company Limited (HKG:1171) makes use of debt. But the real question is whether this debt is making the company risky.

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Yankuang Energy Group

How Much Debt Does Yankuang Energy Group Carry?

The image below, which you can click on for greater detail, shows that Yankuang Energy Group had debt of CN¥87.5b at the end of September 2022, a reduction from CN¥98.9b over a year. However, it does have CN¥50.0b in cash offsetting this, leading to net debt of about CN¥37.5b.

How Strong Is Yankuang Energy Group's Balance Sheet?

According to the last reported balance sheet, Yankuang Energy Group had liabilities of CN¥74.2b due within 12 months, and liabilities of CN¥99.3b due beyond 12 months. Offsetting these obligations, it had cash of CN¥50.0b as well as receivables valued at CN¥21.1b due within 12 months. So its liabilities total CN¥102.3b more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Yankuang Energy Group is worth a massive CN¥175.8b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Yankuang Energy Group's net debt is only 0.55 times its EBITDA. And its EBIT covers its interest expense a whopping 40.5 times over. So we're pretty relaxed about its super-conservative use of debt. Even more impressive was the fact that Yankuang Energy Group grew its EBIT by 137% over twelve months. If maintained that growth will make the debt even more manageable in the years ahead. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Yankuang Energy Group 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Yankuang Energy Group produced sturdy free cash flow equating to 71% 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.

Our View

Happily, Yankuang Energy Group's impressive interest cover implies it has the upper hand on its debt. But, on a more sombre note, we are a little concerned by its level of total liabilities. Looking at the bigger picture, we think Yankuang Energy Group's use of debt seems quite reasonable and we're not concerned about it. After all, sensible leverage can boost returns on equity. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Yankuang Energy Group is showing 2 warning signs in our investment analysis , and 1 of those is potentially serious...

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.