Does Inner Mongolia ERDOS ResourcesLtd (SHSE:600295) Have A Healthy Balance Sheet?

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.' 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. We can see that Inner Mongolia ERDOS Resources Co.,Ltd. (SHSE:600295) does use debt in its business. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. 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. 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. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Inner Mongolia ERDOS ResourcesLtd

What Is Inner Mongolia ERDOS ResourcesLtd's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Inner Mongolia ERDOS ResourcesLtd had CN¥6.68b of debt in March 2024, down from CN¥8.19b, one year before. However, it does have CN¥4.74b in cash offsetting this, leading to net debt of about CN¥1.94b.

A Look At Inner Mongolia ERDOS ResourcesLtd's Liabilities

The latest balance sheet data shows that Inner Mongolia ERDOS ResourcesLtd had liabilities of CN¥17.4b due within a year, and liabilities of CN¥4.38b falling due after that. Offsetting this, it had CN¥4.74b in cash and CN¥2.28b in receivables that were due within 12 months. So its liabilities total CN¥14.7b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of CN¥23.8b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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 ERDOS ResourcesLtd has a low debt to EBITDA ratio of only 0.38. But the really cool thing is that it actually managed to receive more interest than it paid, over the last year. So there's no doubt this company can take on debt while staying cool as a cucumber. In fact Inner Mongolia ERDOS ResourcesLtd's saving grace is its low debt levels, because its EBIT has tanked 53% in the last twelve months. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. When analysing debt levels, the balance sheet is the obvious place to start. But it is Inner Mongolia ERDOS ResourcesLtd's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Happily for any shareholders, Inner Mongolia ERDOS ResourcesLtd 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

Inner Mongolia ERDOS ResourcesLtd's EBIT growth rate was a real negative on this analysis, although the other factors we considered were considerably better. In particular, we are dazzled with its interest cover. When we consider all the factors mentioned above, we do feel a bit cautious about Inner Mongolia ERDOS ResourcesLtd'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. There's no doubt that we learn most about debt from the balance sheet. 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 ERDOS ResourcesLtd you should be aware of.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com