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 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 Nonferrous Mining Corporation Limited (HKG:1258) does carry debt. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
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. If things get really bad, the lenders can take control of the business. 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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is China Nonferrous Mining’s Net Debt?
As you can see below, at the end of June 2020, China Nonferrous Mining had US$1.36b of debt, up from US$1.23b a year ago. Click the image for more detail. However, it does have US$579.3m in cash offsetting this, leading to net debt of about US$777.5m.
How Strong Is China Nonferrous Mining’s Balance Sheet?
The latest balance sheet data shows that China Nonferrous Mining had liabilities of US$1.03b due within a year, and liabilities of US$1.07b falling due after that. Offsetting this, it had US$579.3m in cash and US$211.9m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$1.3b.
The deficiency here weighs heavily on the US$828.3m 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 definitely think shareholders need to watch this one closely. After all, China Nonferrous Mining would likely require a major re-capitalisation if it had to pay its creditors today.
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.
China Nonferrous Mining’s net debt to EBITDA ratio of about 1.8 suggests only moderate use of debt. And its strong interest cover of 22.6 times, makes us even more comfortable. We saw China Nonferrous Mining grow its EBIT by 4.2% in the last twelve months. That’s far from incredible but it is a good thing, when it comes to paying off debt. The balance sheet is clearly the area to focus on when you are analysing debt. 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 it’s worth checking how much of that EBIT is backed by free cash flow. Over the last three years, China Nonferrous Mining 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.
On the face of it, China Nonferrous Mining’s conversion of EBIT to free cash flow left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Overall, it seems to us that China Nonferrous Mining’s balance sheet is really quite a risk to the business. So we’re almost as wary of this stock as a hungry kitten is about falling into its owner’s fish pond: once bitten, twice shy, as they say. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet – far from it. Take risks, for example – China Nonferrous Mining has 3 warning signs we think you should be aware of.
At the end of the day, it’s often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It’s free.
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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. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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