Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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. We can see that CGN New Energy Holdings Co., Ltd. (HKG:1811) does use debt in its business. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
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. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
What Is CGN New Energy Holdings's Net Debt?
As you can see below, CGN New Energy Holdings had US$5.86b of debt, at December 2023, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has US$301.7m in cash leading to net debt of about US$5.56b.
A Look At CGN New Energy Holdings' Liabilities
The latest balance sheet data shows that CGN New Energy Holdings had liabilities of US$2.00b due within a year, and liabilities of US$4.66b falling due after that. Offsetting these obligations, it had cash of US$301.7m as well as receivables valued at US$1.31b due within 12 months. So its liabilities total US$5.05b more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the US$1.26b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, CGN New Energy Holdings would likely require a major re-capitalisation if it had to pay its creditors today.
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 a net debt to EBITDA ratio of 6.3, it's fair to say CGN New Energy Holdings does have a significant amount of debt. But the good news is that it boasts fairly comforting interest cover of 2.6 times, suggesting it can responsibly service its obligations. More concerning, CGN New Energy Holdings saw its EBIT drop by 6.3% in the last twelve months. If it keeps going like that paying off its debt will be like running on a treadmill -- a lot of effort for not much advancement. 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 CGN New Energy Holdings 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, CGN New Energy Holdings burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
Our View
To be frank both CGN New Energy Holdings's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. And even its interest cover fails to inspire much confidence. Considering all the factors previously mentioned, we think that CGN New Energy Holdings really is carrying too much debt. To our minds, that means the stock is rather high risk, and probably one to avoid; but to each their own (investing) style. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. To that end, you should learn about the 2 warning signs we've spotted with CGN New Energy Holdings (including 1 which doesn't sit too well with us) .
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.
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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.