Is Inner Mongolia Dian Tou Energy (SZSE:002128) Using Too Much Debt?

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.' 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. Importantly, Inner Mongolia Dian Tou Energy Corporation Limited (SZSE:002128) does carry debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Inner Mongolia Dian Tou Energy

How Much Debt Does Inner Mongolia Dian Tou Energy Carry?

You can click the graphic below for the historical numbers, but it shows that Inner Mongolia Dian Tou Energy had CN¥8.16b of debt in September 2024, down from CN¥8.69b, one year before. However, because it has a cash reserve of CN¥4.74b, its net debt is less, at about CN¥3.41b.

How Strong Is Inner Mongolia Dian Tou Energy's Balance Sheet?

According to the last reported balance sheet, Inner Mongolia Dian Tou Energy had liabilities of CN¥6.59b due within 12 months, and liabilities of CN¥8.37b due beyond 12 months. On the other hand, it had cash of CN¥4.74b and CN¥4.42b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥5.80b.

Since publicly traded Inner Mongolia Dian Tou Energy shares are worth a total of CN¥44.2b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Inner Mongolia Dian Tou Energy has a low debt to EBITDA ratio of only 0.35. And remarkably, despite having net debt, it actually received more in interest over the last twelve months than it had to pay. So there's no doubt this company can take on debt while staying cool as a cucumber. Also positive, Inner Mongolia Dian Tou Energy grew its EBIT by 29% in the last year, and that should make it easier to pay down debt, going forward. 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 Inner Mongolia Dian Tou Energy 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 company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Inner Mongolia Dian Tou Energy's free cash flow amounted to 28% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

The good news is that Inner Mongolia Dian Tou Energy's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But, on a more sombre note, we are a little concerned by its conversion of EBIT to free cash flow. When we consider the range of factors above, it looks like Inner Mongolia Dian Tou Energy is pretty sensible with its use of debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of Inner Mongolia Dian Tou Energy's earnings per share history for free.

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.