Inner Mongolia Baotou Steel Union (SHSE:600010) Seems To Be Using A Lot Of Debt

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. As with many other companies Inner Mongolia Baotou Steel Union Co., Ltd. (SHSE:600010) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. 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 Baotou Steel Union

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

As you can see below, at the end of September 2024, Inner Mongolia Baotou Steel Union had CN¥52.9b of debt, up from CN¥48.6b a year ago. Click the image for more detail. However, it also had CN¥8.70b in cash, and so its net debt is CN¥44.2b.

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

According to the last reported balance sheet, Inner Mongolia Baotou Steel Union had liabilities of CN¥67.2b due within 12 months, and liabilities of CN¥25.2b due beyond 12 months. Offsetting this, it had CN¥8.70b in cash and CN¥12.3b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥71.4b.

This deficit is considerable relative to its very significant market capitalization of CN¥80.7b, so it does suggest shareholders should keep an eye on Inner Mongolia Baotou Steel Union'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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Weak interest cover of 0.78 times and a disturbingly high net debt to EBITDA ratio of 7.8 hit our confidence in Inner Mongolia Baotou Steel Union like a one-two punch to the gut. The debt burden here is substantial. Worse, Inner Mongolia Baotou Steel Union's EBIT was down 44% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Inner Mongolia Baotou Steel Union will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Inner Mongolia Baotou Steel Union created free cash flow amounting to 5.5% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

On the face of it, Inner Mongolia Baotou Steel Union's interest cover left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. And furthermore, its conversion of EBIT to free cash flow also fails to instill confidence. Taking into account all the aforementioned factors, it looks like Inner Mongolia Baotou Steel Union has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. 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. To that end, you should be aware of the 2 warning signs we've spotted with Inner Mongolia Baotou Steel Union .

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.