The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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. Importantly, Zhaojin Mining Industry Company Limited (HKG:1818) does carry debt. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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 Zhaojin Mining Industry's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of December 2018 Zhaojin Mining Industry had CN¥14.7b of debt, an increase on CN¥13.2b, over one year. However, because it has a cash reserve of CN¥1.74b, its net debt is less, at about CN¥13.0b.
How Strong Is Zhaojin Mining Industry's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Zhaojin Mining Industry had liabilities of CN¥11.8b due within 12 months and liabilities of CN¥7.28b due beyond that. On the other hand, it had cash of CN¥1.74b and CN¥2.45b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥14.9b.
While this might seem like a lot, it is not so bad since Zhaojin Mining Industry has a market capitalization of CN¥30.2b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Zhaojin Mining Industry shareholders face the double whammy of a high net debt to EBITDA ratio (5.9), and fairly weak interest coverage, since EBIT is just 2.2 times the interest expense. The debt burden here is substantial. Even worse, Zhaojin Mining Industry saw its EBIT tank 28% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Zhaojin Mining Industry 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.
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. Over the last three years, Zhaojin Mining Industry recorded negative free cash flow, in total. 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.
To be frank both Zhaojin Mining Industry's net debt to EBITDA and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. Having said that, its ability to handle its total liabilities isn't such a worry. Taking into account all the aforementioned factors, it looks like Zhaojin Mining Industry has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. Over time, share prices tend to follow earnings per share, so if you're interested in Zhaojin Mining Industry, you may well want to click here to check an interactive graph of its earnings per share history.
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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