Is Inner Mongolia ERDOS ResourcesLtd (SHSE:600295) Using Too Much Debt?

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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. 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?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Inner Mongolia ERDOS ResourcesLtd

What Is Inner Mongolia ERDOS ResourcesLtd's Net Debt?

The image below, which you can click on for greater detail, shows that at June 2024 Inner Mongolia ERDOS ResourcesLtd had debt of CN¥10.1b, up from CN¥9.22b in one year. However, it does have CN¥6.86b in cash offsetting this, leading to net debt of about CN¥3.23b.

How Strong Is Inner Mongolia ERDOS ResourcesLtd's Balance Sheet?

The latest balance sheet data shows that Inner Mongolia ERDOS ResourcesLtd had liabilities of CN¥21.4b due within a year, and liabilities of CN¥3.95b falling due after that. Offsetting these obligations, it had cash of CN¥6.86b as well as receivables valued at CN¥2.10b due within 12 months. So its liabilities total CN¥16.4b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of CN¥24.3b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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.

Inner Mongolia ERDOS ResourcesLtd has net debt of just 0.62 times EBITDA, suggesting it could ramp leverage without breaking a sweat. 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. The modesty of its debt load may become crucial for Inner Mongolia ERDOS ResourcesLtd if management cannot prevent a repeat of the 27% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Inner Mongolia ERDOS ResourcesLtd can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Inner Mongolia ERDOS ResourcesLtd actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

Based on what we've seen Inner Mongolia ERDOS ResourcesLtd is not finding it easy, given its EBIT growth rate, but the other factors we considered give us cause to be optimistic. 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. We've identified 1 warning sign with Inner Mongolia ERDOS ResourcesLtd , and understanding them should be part of your investment process.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.