Is Ouhua Energy Holdings (SGX:AJ2) Using Too Much Debt?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Ouhua Energy Holdings Limited (SGX:AJ2) makes use of debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, plenty of companies use debt to fund growth, without any negative consequences. 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 Ouhua Energy Holdings

What Is Ouhua Energy Holdings's Debt?

As you can see below, Ouhua Energy Holdings had CN¥202.1m of debt at December 2021, down from CN¥252.4m a year prior. On the flip side, it has CN¥143.9m in cash leading to net debt of about CN¥58.2m.

A Look At Ouhua Energy Holdings' Liabilities

The latest balance sheet data shows that Ouhua Energy Holdings had liabilities of CN¥406.8m due within a year, and liabilities of CN¥10.3m falling due after that. On the other hand, it had cash of CN¥143.9m and CN¥75.6m worth of receivables due within a year. So it has liabilities totalling CN¥197.7m more than its cash and near-term receivables, combined.

This deficit casts a shadow over the CN¥129.7m company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. At the end of the day, Ouhua Energy Holdings would probably need a major re-capitalization if its creditors were to demand repayment.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Looking at its net debt to EBITDA of 0.75 and interest cover of 5.3 times, it seems to us that Ouhua Energy Holdings is probably using debt in a pretty reasonable way. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Pleasingly, Ouhua Energy Holdings is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 209% gain in the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Ouhua Energy Holdings's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, Ouhua Energy Holdings recorded free cash flow worth 71% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

On our analysis Ouhua Energy Holdings's EBIT growth rate should signal that it won't have too much trouble with its debt. However, our other observations weren't so heartening. In particular, level of total liabilities gives us cold feet. When we consider all the factors mentioned above, we do feel a bit cautious about Ouhua Energy Holdings's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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. Case in point: We've spotted 2 warning signs for Ouhua Energy Holdings you should be aware of, and 1 of them is concerning.

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.