Is China Coal Energy (HKG:1898) Using Too Much Debt?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. As with many other companies China Coal Energy Company Limited (HKG:1898) makes use of debt. But should shareholders be worried about its use of debt?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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 Coal Energy

What Is China Coal Energy's Debt?

As you can see below, China Coal Energy had CN¥69.1b of debt at June 2024, down from CN¥79.6b a year prior. However, its balance sheet shows it holds CN¥94.2b in cash, so it actually has CN¥25.1b net cash.

How Strong Is China Coal Energy's Balance Sheet?

The latest balance sheet data shows that China Coal Energy had liabilities of CN¥100.5b due within a year, and liabilities of CN¥72.9b falling due after that. Offsetting this, it had CN¥94.2b in cash and CN¥18.5b in receivables that were due within 12 months. So it has liabilities totalling CN¥60.7b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since China Coal Energy has a huge market capitalization of CN¥161.1b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. Despite its noteworthy liabilities, China Coal Energy boasts net cash, so it's fair to say it does not have a heavy debt load!

But the bad news is that China Coal Energy has seen its EBIT plunge 17% in the last twelve months. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. 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 Coal 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. China Coal 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 Coal Energy generated free cash flow amounting to a very robust 83% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Summing Up

While China Coal Energy does have more liabilities than liquid assets, it also has net cash of CN¥25.1b. The cherry on top was that in converted 83% of that EBIT to free cash flow, bringing in CN¥21b. So we don't have any problem with China Coal Energy's use of debt. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. To that end, you should be aware of the 1 warning sign we've spotted with China Coal Energy .

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.