We Think Baowu Magnesium Technology (SZSE:002182) Is Taking Some Risk With Its Debt

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. Importantly, Baowu Magnesium Technology Co., Ltd. (SZSE:002182) does carry debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Baowu Magnesium Technology

What Is Baowu Magnesium Technology's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2024 Baowu Magnesium Technology had debt of CN¥5.35b, up from CN¥3.38b in one year. However, because it has a cash reserve of CN¥242.8m, its net debt is less, at about CN¥5.11b.

How Healthy Is Baowu Magnesium Technology's Balance Sheet?

We can see from the most recent balance sheet that Baowu Magnesium Technology had liabilities of CN¥4.26b falling due within a year, and liabilities of CN¥2.25b due beyond that. Offsetting these obligations, it had cash of CN¥242.8m as well as receivables valued at CN¥2.33b due within 12 months. So its liabilities total CN¥3.94b more than the combination of its cash and short-term receivables.

Baowu Magnesium Technology has a market capitalization of CN¥13.7b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

With a net debt to EBITDA ratio of 7.5, it's fair to say Baowu Magnesium Technology does have a significant amount of debt. But the good news is that it boasts fairly comforting interest cover of 3.4 times, suggesting it can responsibly service its obligations. Fortunately, Baowu Magnesium Technology grew its EBIT by 9.6% in the last year, slowly shrinking its debt relative to earnings. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Baowu Magnesium Technology 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Baowu Magnesium Technology saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both Baowu Magnesium Technology's net debt to EBITDA and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Baowu Magnesium Technology stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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 3 warning signs with Baowu Magnesium Technology (at least 2 which are a bit concerning) , and understanding them should be part of your investment process.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.