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.' 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. Importantly, Tianneng Power International Limited (HKG:819) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Tianneng Power International

What Is Tianneng Power International's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2022 Tianneng Power International had CN¥7.62b of debt, an increase on CN¥6.05b, over one year. However, it does have CN¥11.9b in cash offsetting this, leading to net cash of CN¥4.30b.

A Look At Tianneng Power International's Liabilities

We can see from the most recent balance sheet that Tianneng Power International had liabilities of CN¥21.6b falling due within a year, and liabilities of CN¥2.20b due beyond that. Offsetting this, it had CN¥11.9b in cash and CN¥4.36b in receivables that were due within 12 months. So its liabilities total CN¥7.47b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of CN¥7.53b, so it does suggest shareholders should keep an eye on Tianneng Power International's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution. While it does have liabilities worth noting, Tianneng Power International also has more cash than debt, so we're pretty confident it can manage its debt safely.

In fact Tianneng Power International's saving grace is its low debt levels, because its EBIT has tanked 43% in the last twelve months. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Tianneng Power International can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Tianneng Power International has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last three years, Tianneng Power International recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Summing Up

While Tianneng Power International does have more liabilities than liquid assets, it also has net cash of CN¥4.30b. Despite its cash we think that Tianneng Power International seems to struggle to grow its EBIT, so we are wary of the stock. 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. We've identified 2 warning signs with Tianneng Power International , and understanding them should be part of your investment process.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.