Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 China Nonferrous Mining Corporation Limited (HKG:1258) does use debt in its business. But the real question is whether this debt is making the company risky.
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. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.
What Is China Nonferrous Mining's Debt?
The chart below, which you can click on for greater detail, shows that China Nonferrous Mining had US$1.23b in debt in June 2019; about the same as the year before. However, it does have US$629.7m in cash offsetting this, leading to net debt of about US$604.0m.
How Healthy Is China Nonferrous Mining's Balance Sheet?
According to the last reported balance sheet, China Nonferrous Mining had liabilities of US$842.0m due within 12 months, and liabilities of US$853.9m due beyond 12 months. On the other hand, it had cash of US$629.7m and US$139.7m worth of receivables due within a year. So it has liabilities totalling US$926.6m more than its cash and near-term receivables, combined.
When you consider that this deficiency exceeds the company's US$663.3m market capitalization, you might well be inclined to review the balance sheet, just like one might study a new partner's social media. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
China Nonferrous Mining has a low net debt to EBITDA ratio of only 1.4. And its EBIT covers its interest expense a whopping 22.8 times over. So we're pretty relaxed about its super-conservative use of debt. Shareholders should be aware that China Nonferrous Mining's EBIT was down 28% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since China Nonferrous Mining will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Considering the last three years, China Nonferrous Mining actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for and improvement.
To be frank both China Nonferrous Mining's level of total liabilities and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But on the bright side, its interest cover is a good sign, and makes us more optimistic. We're quite clear that we consider China Nonferrous Mining to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. Another positive for shareholders is that it pays dividends. So if you like receiving those dividend payments, check China Nonferrous Mining's dividend history, without delay!
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.
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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.