David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that China Coal Energy Company Limited (HKG:1898) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. 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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is China Coal Energy's Net Debt?

The image below, which you can click on for greater detail, shows that China Coal Energy had debt of CN¥71.2b at the end of March 2024, a reduction from CN¥83.4b over a year. However, its balance sheet shows it holds CN¥90.5b in cash, so it actually has CN¥19.3b net cash.

How Strong Is China Coal Energy's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that China Coal Energy had liabilities of CN¥91.3b due within 12 months and liabilities of CN¥71.0b due beyond that. Offsetting this, it had CN¥90.5b in cash and CN¥18.5b in receivables that were due within 12 months. So its liabilities total CN¥53.3b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since China Coal Energy has a huge market capitalization of CN¥135.3b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt. While it does have liabilities worth noting, China Coal Energy also has more cash than debt, so we're pretty confident it can manage its debt safely.

The modesty of its debt load may become crucial for China Coal Energy if management cannot prevent a repeat of the 26% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if China Coal Energy 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. China Coal Energy may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last three years, China Coal Energy recorded free cash flow worth a fulsome 89% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Summing Up

Although China Coal Energy's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of CN¥19.3b. The cherry on top was that in converted 89% of that EBIT to free cash flow, bringing in CN¥18b. So we are not troubled with China Coal Energy's debt use. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 2 warning signs with China Coal Energy (at least 1 which is a bit concerning) , 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.

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.