Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. We can see that Huaihe Energy (Group) Co.,Ltd (SHSE:600575) does use debt in its business. But is this debt a concern to shareholders?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

What Is Huaihe Energy (Group)Ltd's Net Debt?

The image below, which you can click on for greater detail, shows that at December 2023 Huaihe Energy (Group)Ltd had debt of CN¥6.32b, up from CN¥3.45b in one year. However, it also had CN¥2.50b in cash, and so its net debt is CN¥3.82b.

A Look At Huaihe Energy (Group)Ltd's Liabilities

According to the last reported balance sheet, Huaihe Energy (Group)Ltd had liabilities of CN¥6.46b due within 12 months, and liabilities of CN¥4.70b due beyond 12 months. Offsetting these obligations, it had cash of CN¥2.50b as well as receivables valued at CN¥2.16b due within 12 months. So it has liabilities totalling CN¥6.50b more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of CN¥9.96b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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.

We'd say that Huaihe Energy (Group)Ltd's moderate net debt to EBITDA ratio ( being 2.1), indicates prudence when it comes to debt. And its strong interest cover of 1k times, makes us even more comfortable. Sadly, Huaihe Energy (Group)Ltd's EBIT actually dropped 7.4% in the last year. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Huaihe Energy (Group)Ltd will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Huaihe Energy (Group)Ltd recorded free cash flow worth 68% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

When it comes to the balance sheet, the standout positive for Huaihe Energy (Group)Ltd was the fact that it seems able to cover its interest expense with its EBIT confidently. But the other factors we noted above weren't so encouraging. For instance it seems like it has to struggle a bit to grow its EBIT. It's also worth noting that Huaihe Energy (Group)Ltd is in the Infrastructure industry, which is often considered to be quite defensive. Looking at all this data makes us feel a little cautious about Huaihe Energy (Group)Ltd's debt levels. 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. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 1 warning sign with Huaihe Energy (Group)Ltd , and understanding them should be part of your investment process.

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.