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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, China Coal Energy Company Limited (HKG:1898) does carry debt. But is this debt a concern to shareholders?
When Is Debt A Problem?
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. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does China Coal Energy Carry?
You can click the graphic below for the historical numbers, but it shows that as of March 2019 China Coal Energy had CN¥101.0b of debt, an increase on CN¥91.1b, over one year. However, it does have CN¥28.7b in cash offsetting this, leading to net debt of about CN¥72.3b.
A Look At China Coal Energy's Liabilities
The latest balance sheet data shows that China Coal Energy had liabilities of CN¥66.3b due within a year, and liabilities of CN¥89.7b falling due after that. Offsetting this, it had CN¥28.7b in cash and CN¥9.79b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥117.4b.
The deficiency here weighs heavily on the CN¥49.5b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt At the end of the day, China Coal Energy would probably need a major re-capitalization if its creditors were to demand repayment.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
With net debt to EBITDA of 3.8 China Coal Energy has a fairly noticeable amount of debt. On the plus side, its EBIT was 7.0 times its interest expense, and its net debt to EBITDA, was quite high, at 3.8. Also relevant is that China Coal Energy has grown its EBIT by a very respectable 23% in the last year, thus enhancing its ability to pay down debt. There's no doubt that we learn most about debt from the balance sheet. 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. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, China Coal Energy recorded free cash flow worth a fulsome 96% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.
While China Coal Energy's level of total liabilities has us nervous. To wit both its conversion of EBIT to free cash flow and EBIT growth rate were encouraging signs. We think that China Coal Energy's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. Given China Coal Energy has a strong balance sheet is profitable and pays a dividend, it would be good to know how fast its dividends are growing, if at all. You can find out instantly by clicking this link.
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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