Here's Why China Longyuan Power Group (HKG:916) Is Weighed Down By Its Debt Load

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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that China Longyuan Power Group Corporation Limited (HKG:916) does use debt in its business. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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 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 Longyuan Power Group

What Is China Longyuan Power Group's Debt?

The image below, which you can click on for greater detail, shows that at June 2022 China Longyuan Power Group had debt of CN¥107.9b, up from CN¥89.5b in one year. However, because it has a cash reserve of CN¥15.6b, its net debt is less, at about CN¥92.3b.

A Look At China Longyuan Power Group's Liabilities

Zooming in on the latest balance sheet data, we can see that China Longyuan Power Group had liabilities of CN¥66.8b due within 12 months and liabilities of CN¥70.2b due beyond that. Offsetting these obligations, it had cash of CN¥15.6b as well as receivables valued at CN¥30.0b due within 12 months. So it has liabilities totalling CN¥91.4b more than its cash and near-term receivables, combined.

This is a mountain of leverage even relative to its gargantuan market capitalization of CN¥95.7b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

China Longyuan Power Group has a debt to EBITDA ratio of 4.6 and its EBIT covered its interest expense 4.0 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Even more troubling is the fact that China Longyuan Power Group actually let its EBIT decrease by 8.5% over the last year. If that earnings trend continues the company will face an uphill battle to pay off its 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 Longyuan Power Group'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 company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Considering the last three years, China Longyuan Power Group actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Our View

To be frank both China Longyuan Power Group's net debt to EBITDA and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. And furthermore, its EBIT growth rate also fails to instill confidence. We're quite clear that we consider China Longyuan Power Group to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 3 warning signs for China Longyuan Power Group (1 is concerning!) that you should be aware of before investing here.

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.