Is Zhejiang Huayou Cobalt (SHSE:603799) Using Too Much Debt?

Warren Buffett famously said, '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 Zhejiang Huayou Cobalt Co., Ltd (SHSE:603799) makes use of debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Zhejiang Huayou Cobalt

What Is Zhejiang Huayou Cobalt's Net 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.

A Look At Zhejiang Huayou Cobalt's Liabilities

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 this, it had CN¥18.0b in cash and CN¥8.00b in receivables that were due within 12 months. So it has liabilities totalling CN¥58.7b more than its cash and near-term receivables, combined.

When you consider that this deficiency exceeds the company's CN¥54.3b market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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

Zhejiang Huayou Cobalt has a debt to EBITDA ratio of 4.4 and its EBIT covered its interest expense 4.6 times. 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. When analysing debt levels, the balance sheet is the obvious place to start. 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 want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Zhejiang Huayou Cobalt saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

We'd go so far as to say Zhejiang Huayou Cobalt's conversion of EBIT to free cash flow was disappointing. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. We're quite clear that we consider Zhejiang Huayou Cobalt to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Zhejiang Huayou Cobalt (of which 1 can't be ignored!) you should know about.

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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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.