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 Zijin Mining Group Company Limited (HKG:2899) does use debt in its business. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Zijin Mining Group's Net Debt?
As you can see below, at the end of September 2019, Zijin Mining Group had CN¥43.9b of debt, up from CN¥37.6b a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥7.35b, its net debt is less, at about CN¥36.6b.
How Healthy Is Zijin Mining Group's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Zijin Mining Group had liabilities of CN¥36.8b due within 12 months and liabilities of CN¥33.0b due beyond that. Offsetting these obligations, it had cash of CN¥7.35b as well as receivables valued at CN¥4.08b due within 12 months. So its liabilities total CN¥58.4b more than the combination of its cash and short-term receivables.
This deficit is considerable relative to its very significant market capitalization of CN¥75.4b, so it does suggest shareholders should keep an eye on Zijin Mining Group's use of debt. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry.
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 net debt to EBITDA of 3.0 Zijin Mining Group has a fairly noticeable amount of debt. But the high interest coverage of 9.3 suggests it can easily service that debt. Shareholders should be aware that Zijin Mining Group's EBIT was down 22% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Zijin Mining Group's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Zijin Mining Group's free cash flow amounted to 28% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
We'd go so far as to say Zijin Mining Group's EBIT growth rate was disappointing. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Overall, we think it's fair to say that Zijin Mining Group has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.
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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