Here's Why Chongyi Zhangyuan Tungsten (SZSE:002378) Has A Meaningful Debt Burden

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies Chongyi Zhangyuan Tungsten Co., Ltd. (SZSE:002378) makes use of debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. If things get really bad, the lenders can take control of the business. 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. 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.

View our latest analysis for Chongyi Zhangyuan Tungsten

How Much Debt Does Chongyi Zhangyuan Tungsten Carry?

The image below, which you can click on for greater detail, shows that at March 2024 Chongyi Zhangyuan Tungsten had debt of CN¥2.08b, up from CN¥1.59b in one year. However, it also had CN¥410.8m in cash, and so its net debt is CN¥1.67b.

How Strong Is Chongyi Zhangyuan Tungsten's Balance Sheet?

The latest balance sheet data shows that Chongyi Zhangyuan Tungsten had liabilities of CN¥1.94b due within a year, and liabilities of CN¥765.4m falling due after that. Offsetting these obligations, it had cash of CN¥410.8m as well as receivables valued at CN¥849.3m due within 12 months. So its liabilities total CN¥1.45b more than the combination of its cash and short-term receivables.

Given Chongyi Zhangyuan Tungsten has a market capitalization of CN¥8.94b, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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's debt is 4.2 times its EBITDA, and its EBIT cover its interest expense 2.9 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Even more troubling is the fact that Chongyi Zhangyuan Tungsten actually let its EBIT decrease by 6.7% over the last year. If that earnings trend continues the company will face an uphill battle to pay off its debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Chongyi Zhangyuan Tungsten 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.

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, 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

To be frank both Chongyi Zhangyuan Tungsten's interest cover and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. Having said that, its ability to handle its total liabilities isn't such a worry. Once we consider all the factors above, together, it seems to us that Chongyi Zhangyuan Tungsten's debt is making it 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. For example Chongyi Zhangyuan Tungsten has 3 warning signs (and 1 which is significant) we think you should know about.

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.