Is Zhejiang Huayou Cobalt (SHSE:603799) A Risky Investment?

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that Zhejiang Huayou Cobalt Co., Ltd (SHSE:603799) does have debt on its balance sheet. 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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Zhejiang Huayou Cobalt

What Is Zhejiang Huayou Cobalt's Debt?

As you can see below, at the end of September 2024, Zhejiang Huayou Cobalt had CN¥61.9b of debt, up from CN¥51.7b a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥18.0b, its net debt is less, at about CN¥43.9b.

How Healthy Is Zhejiang Huayou Cobalt's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Zhejiang Huayou Cobalt had liabilities of CN¥52.7b due within 12 months and liabilities of CN¥32.0b due beyond that. Offsetting these obligations, it had cash of CN¥18.0b as well as receivables valued at CN¥8.00b due within 12 months. So its liabilities total CN¥58.7b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of CN¥60.8b, so it does suggest shareholders should keep an eye on Zhejiang Huayou Cobalt's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Zhejiang Huayou Cobalt's debt is 4.4 times its EBITDA, and its EBIT cover its interest expense 4.6 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. One way Zhejiang Huayou Cobalt could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 15%, as it did over the last year. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Zhejiang Huayou Cobalt's ability to maintain a healthy balance sheet going forward. 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. During the last three years, Zhejiang Huayou Cobalt burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

Mulling over Zhejiang Huayou Cobalt's attempt at converting EBIT to free cash flow, we're certainly not enthusiastic. But at least it's pretty decent at growing its EBIT; that's encouraging. Overall, we think it's fair to say that Zhejiang Huayou Cobalt has enough debt that there are some real risks around the balance sheet. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Be aware that Zhejiang Huayou Cobalt is showing 2 warning signs in our investment analysis , and 1 of those can't be ignored...

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. 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.