Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. As with many other companies Zhongyu Energy Holdings Limited (HKG:3633) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Zhongyu Energy Holdings

What Is Zhongyu Energy Holdings's Debt?

As you can see below, Zhongyu Energy Holdings had HK$11.4b of debt, at June 2022, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has HK$3.38b in cash leading to net debt of about HK$8.02b.

How Strong Is Zhongyu Energy Holdings' Balance Sheet?

We can see from the most recent balance sheet that Zhongyu Energy Holdings had liabilities of HK$10.1b falling due within a year, and liabilities of HK$6.65b due beyond that. On the other hand, it had cash of HK$3.38b and HK$2.62b worth of receivables due within a year. So it has liabilities totalling HK$10.8b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Zhongyu Energy Holdings is worth HK$18.2b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

With net debt to EBITDA of 4.4 Zhongyu Energy Holdings has a fairly noticeable amount of debt. On the plus side, its EBIT was 7.2 times its interest expense, and its net debt to EBITDA, was quite high, at 4.4. If Zhongyu Energy Holdings can keep growing EBIT at last year's rate of 17% over the last year, then it will find its debt load easier to manage. There's no doubt that we learn most about debt from the balance sheet. But it is Zhongyu 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Considering the last three years, Zhongyu Energy Holdings 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

While Zhongyu Energy Holdings's net debt to EBITDA makes us cautious about it, its track record of converting EBIT to free cash flow is no better. But its not so bad at growing its EBIT. We should also note that Gas Utilities industry companies like Zhongyu Energy Holdings commonly do use debt without problems. Taking the abovementioned factors together we do think Zhongyu Energy Holdings's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. Be aware that Zhongyu Energy Holdings is showing 4 warning signs in our investment analysis , and 1 of those shouldn't be ignored...

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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.