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 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. We can see that China Longyuan Power Group Corporation Limited (HKG:916) does use debt in its business. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. If things get really bad, the lenders can take control of the business. 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. 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.

See our latest analysis for China Longyuan Power Group

What Is China Longyuan Power Group's Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2022 China Longyuan Power Group had CN¥120.6b of debt, an increase on CN¥105.0b, over one year. However, it does have CN¥18.8b in cash offsetting this, leading to net debt of about CN¥101.9b.

How Healthy Is China Longyuan Power Group's Balance Sheet?

The latest balance sheet data shows that China Longyuan Power Group had liabilities of CN¥74.0b due within a year, and liabilities of CN¥69.4b falling due after that. Offsetting these obligations, it had cash of CN¥18.8b as well as receivables valued at CN¥28.1b due within 12 months. So it has liabilities totalling CN¥96.6b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the CN¥60.5b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. At the end of the day, China Longyuan Power Group would probably need a major re-capitalization if its creditors were to demand repayment.

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.

China Longyuan Power Group's debt is 4.2 times its EBITDA, and its EBIT cover its interest expense 4.3 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Notably, China Longyuan Power Group's EBIT was pretty flat over the last year, which isn't ideal given the debt load. 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'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 it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, China Longyuan Power Group reported free cash flow worth 13% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

Mulling over China Longyuan Power Group's attempt at staying on top of its total liabilities, we're certainly not enthusiastic. Having said that, its ability to grow its EBIT isn't such a worry. 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. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 2 warning signs for China Longyuan Power Group 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.