Is China Longyuan Power Group (HKG:916) Using Too Much Debt?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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. Importantly, China Longyuan Power Group Corporation Limited (HKG:916) does carry debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. 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 Longyuan Power Group

What Is China Longyuan Power Group's Debt?

As you can see below, at the end of June 2021, China Longyuan Power Group had CN¥89.4b of debt, up from CN¥83.5b a year ago. Click the image for more detail. However, it does have CN¥3.69b in cash offsetting this, leading to net debt of about CN¥85.7b.

A Look At China Longyuan Power Group's Liabilities

The latest balance sheet data shows that China Longyuan Power Group had liabilities of CN¥52.5b due within a year, and liabilities of CN¥57.2b falling due after that. Offsetting this, it had CN¥3.69b in cash and CN¥25.2b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥80.8b.

This deficit is considerable relative to its very significant market capitalization of CN¥94.6b, so it does suggest shareholders should keep an eye on China Longyuan Power Group's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

China Longyuan Power Group's debt is 4.3 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. On the other hand, China Longyuan Power Group grew its EBIT by 22% in the last year. If it can maintain that kind of improvement, its debt load will begin to melt away like glaciers in a warming world. There's no doubt that we learn most about debt from the balance sheet. 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, China Longyuan Power Group recorded negative free cash flow, in total. 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

We'd go so far as to say China Longyuan Power Group's conversion of EBIT to free cash flow was disappointing. But at least it's pretty decent at growing its EBIT; that's encouraging. Once we consider all the factors above, together, it seems to us that China Longyuan Power Group's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 1 warning sign for China Longyuan Power Group that you should be aware of before investing here.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.
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