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 Jiangsu Linyang Energy Co., Ltd. (SHSE:601222) does use debt in its business. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
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. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Jiangsu Linyang Energy's Net Debt?
As you can see below, at the end of September 2023, Jiangsu Linyang Energy had CN¥3.03b of debt, up from CN¥2.75b a year ago. Click the image for more detail. But on the other hand it also has CN¥6.08b in cash, leading to a CN¥3.05b net cash position.
A Look At Jiangsu Linyang Energy's Liabilities
The latest balance sheet data shows that Jiangsu Linyang Energy had liabilities of CN¥5.16b due within a year, and liabilities of CN¥2.69b falling due after that. On the other hand, it had cash of CN¥6.08b and CN¥4.62b worth of receivables due within a year. So it actually has CN¥2.86b more liquid assets than total liabilities.
It's good to see that Jiangsu Linyang Energy has plenty of liquidity on its balance sheet, suggesting conservative management of liabilities. Given it has easily adequate short term liquidity, we don't think it will have any issues with its lenders. Simply put, the fact that Jiangsu Linyang Energy has more cash than debt is arguably a good indication that it can manage its debt safely.
And we also note warmly that Jiangsu Linyang Energy grew its EBIT by 11% last year, making its debt load easier to handle. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Jiangsu Linyang Energy can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Jiangsu Linyang Energy 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. Considering the last three years, Jiangsu Linyang Energy actually recorded a cash outflow, overall. 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 we empathize with investors who find debt concerning, you should keep in mind that Jiangsu Linyang Energy has net cash of CN¥3.05b, as well as more liquid assets than liabilities. On top of that, it increased its EBIT by 11% in the last twelve months. So we don't have any problem with Jiangsu Linyang Energy's use of debt. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 1 warning sign for Jiangsu Linyang Energy that you should be aware of before investing here.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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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.