Does Chongyi Zhangyuan Tungsten (SZSE:002378) 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.' 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 note that Chongyi Zhangyuan Tungsten Co., Ltd. (SZSE:002378) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Chongyi Zhangyuan Tungsten

What Is Chongyi Zhangyuan Tungsten's Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2024 Chongyi Zhangyuan Tungsten had CN¥2.04b of debt, an increase on CN¥1.57b, over one year. On the flip side, it has CN¥373.6m in cash leading to net debt of about CN¥1.66b.

A Look At Chongyi Zhangyuan Tungsten's Liabilities

The latest balance sheet data shows that Chongyi Zhangyuan Tungsten had liabilities of CN¥1.94b due within a year, and liabilities of CN¥928.0m falling due after that. On the other hand, it had cash of CN¥373.6m and CN¥939.8m worth of receivables due within a year. So it has liabilities totalling CN¥1.56b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Chongyi Zhangyuan Tungsten has a market capitalization of CN¥7.06b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Chongyi Zhangyuan Tungsten has a debt to EBITDA ratio of 3.9 and its EBIT covered its interest expense 2.9 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. On the other hand, Chongyi Zhangyuan Tungsten grew its EBIT by 22% in the last year. If sustained, this growth should make that debt evaporate like a scarce drinking water during an unnaturally hot summer. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Chongyi Zhangyuan Tungsten's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Chongyi Zhangyuan Tungsten recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

Chongyi Zhangyuan Tungsten's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. For example its EBIT growth rate was refreshing. Looking at all the angles mentioned above, it does seem to us that Chongyi Zhangyuan Tungsten is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 3 warning signs with Chongyi Zhangyuan Tungsten (at least 1 which shouldn't be ignored) , 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.