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 Yangtze Power Co., Ltd. (SHSE:600900) does carry debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

What Is China Yangtze Power's Net Debt?

As you can see below, at the end of September 2023, China Yangtze Power had CN¥336.0b of debt, up from CN¥112.9b a year ago. Click the image for more detail. However, it also had CN¥7.76b in cash, and so its net debt is CN¥328.3b.

How Strong Is China Yangtze Power's Balance Sheet?

The latest balance sheet data shows that China Yangtze Power had liabilities of CN¥155.6b due within a year, and liabilities of CN¥215.1b falling due after that. Offsetting these obligations, it had cash of CN¥7.76b as well as receivables valued at CN¥24.1b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥338.8b.

This deficit isn't so bad because China Yangtze Power is worth a massive CN¥607.5b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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.

Strangely China Yangtze Power has a sky high EBITDA ratio of 7.4, implying high debt, but a strong interest coverage of 16.0. So either it has access to very cheap long term debt or that interest expense is going to grow! Also relevant is that China Yangtze Power has grown its EBIT by a very respectable 23% in the last year, thus enhancing its ability to pay down debt. 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 China Yangtze Power 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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, China Yangtze Power generated free cash flow amounting to a very robust 93% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Our View

Happily, China Yangtze Power's impressive interest cover implies it has the upper hand on its debt. But the stark truth is that we are concerned by its net debt to EBITDA. Looking at all the aforementioned factors together, it strikes us that China Yangtze Power can handle its debt fairly comfortably. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 2 warning signs for China Yangtze Power (1 is potentially serious!) that you should be aware of before investing here.

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.