Does Inner Mongolia Baotou Steel Union (SHSE:600010) Have A Healthy Balance Sheet?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, Inner Mongolia Baotou Steel Union Co., Ltd. (SHSE:600010) does carry debt. But should shareholders be worried about its use of debt?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Inner Mongolia Baotou Steel Union

What Is Inner Mongolia Baotou Steel Union's Net Debt?

As you can see below, at the end of September 2023, Inner Mongolia Baotou Steel Union had CN¥48.6b of debt, up from CN¥36.4b a year ago. Click the image for more detail. On the flip side, it has CN¥8.45b in cash leading to net debt of about CN¥40.1b.

How Healthy Is Inner Mongolia Baotou Steel Union's Balance Sheet?

The latest balance sheet data shows that Inner Mongolia Baotou Steel Union had liabilities of CN¥69.3b due within a year, and liabilities of CN¥22.7b falling due after that. Offsetting these obligations, it had cash of CN¥8.45b as well as receivables valued at CN¥16.7b due within 12 months. So its liabilities total CN¥66.9b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of CN¥69.9b, so it does suggest shareholders should keep an eye on Inner Mongolia Baotou Steel Union's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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.

Weak interest cover of 1.4 times and a disturbingly high net debt to EBITDA ratio of 7.0 hit our confidence in Inner Mongolia Baotou Steel Union like a one-two punch to the gut. The debt burden here is substantial. However, it should be some comfort for shareholders to recall that Inner Mongolia Baotou Steel Union actually grew its EBIT by a hefty 8,423%, over the last 12 months. If it can keep walking that path it will be in a position to shed its debt with relative ease. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Inner Mongolia Baotou Steel Union 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 it's worth checking how much of that EBIT is backed by free cash flow. Happily for any shareholders, Inner Mongolia Baotou Steel Union actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

We weren't impressed with Inner Mongolia Baotou Steel Union's interest cover, and its net debt to EBITDA made us cautious. But like a ballerina ending on a perfect pirouette, it has not trouble converting EBIT to free cash flow. When we consider all the factors mentioned above, we do feel a bit cautious about Inner Mongolia Baotou Steel Union's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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. Case in point: We've spotted 2 warning signs for Inner Mongolia Baotou Steel Union you should be aware of, and 1 of them makes us a bit uncomfortable.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.