Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Zhengzhou Coal Mining Machinery Group Company Limited (HKG:564) makes use of debt. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Zhengzhou Coal Mining Machinery Group's Debt?
The image below, which you can click on for greater detail, shows that at March 2019 Zhengzhou Coal Mining Machinery Group had debt of CN¥3.58b, up from CN¥3.17b in one year. However, its balance sheet shows it holds CN¥4.00b in cash, so it actually has CN¥423.3m net cash.
How Strong Is Zhengzhou Coal Mining Machinery Group's Balance Sheet?
According to the last reported balance sheet, Zhengzhou Coal Mining Machinery Group had liabilities of CN¥11.1b due within 12 months, and liabilities of CN¥4.50b due beyond 12 months. Offsetting this, it had CN¥4.00b in cash and CN¥9.27b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥2.34b.
Zhengzhou Coal Mining Machinery Group has a market capitalization of CN¥9.69b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt. While it does have liabilities worth noting, Zhengzhou Coal Mining Machinery Group also has more cash than debt, so we're pretty confident it can manage its debt safely.
Even more impressive was the fact that Zhengzhou Coal Mining Machinery Group grew its EBIT by 153% over twelve months. That boost will make it even easier to pay down debt going forward. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Zhengzhou Coal Mining Machinery 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.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. While Zhengzhou Coal Mining Machinery Group has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. In the last two years, Zhengzhou Coal Mining Machinery Group's free cash flow amounted to 22% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
Although Zhengzhou Coal Mining Machinery Group's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of CN¥423m. And we liked the look of last year's 153% year-on-year EBIT growth. So we are not troubled with Zhengzhou Coal Mining Machinery Group's debt use. Given Zhengzhou Coal Mining Machinery Group 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.
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.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at email@example.com. 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.