Here's Why China Gold International Resources (TSE:CGG) Can Manage Its Debt Responsibly

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 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. As with many other companies China Gold International Resources Corp. Ltd. (TSE:CGG) makes use of debt. But the real question is whether this debt is making the company risky.

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. If things get really bad, the lenders can take control of the business. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for China Gold International Resources

What Is China Gold International Resources's Net Debt?

The image below, which you can click on for greater detail, shows that China Gold International Resources had debt of US$1.07b at the end of September 2021, a reduction from US$1.28b over a year. However, because it has a cash reserve of US$302.8m, its net debt is less, at about US$770.2m.

How Healthy Is China Gold International Resources' Balance Sheet?

We can see from the most recent balance sheet that China Gold International Resources had liabilities of US$359.7m falling due within a year, and liabilities of US$1.20b due beyond that. On the other hand, it had cash of US$302.8m and US$12.9m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$1.25b.

Given this deficit is actually higher than the company's market capitalization of US$1.18b, we think shareholders really should watch China Gold International Resources's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

China Gold International Resources's net debt of 1.6 times EBITDA suggests graceful use of debt. And the fact that its trailing twelve months of EBIT was 9.9 times its interest expenses harmonizes with that theme. Even more impressive was the fact that China Gold International Resources grew its EBIT by 268% over twelve months. If maintained that growth will make the debt even more manageable in the years ahead. 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 Gold International Resources can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, China Gold International Resources recorded free cash flow worth a fulsome 97% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Our View

China Gold International Resources's conversion of EBIT to free cash flow suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But the stark truth is that we are concerned by its level of total liabilities. Looking at all the aforementioned factors together, it strikes us that China Gold International Resources can handle its debt fairly comfortably. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 1 warning sign for China Gold International Resources that you should be aware of before investing here.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.