Is Yunnan Lincang Xinyuan Germanium IndustryLTD (SZSE:002428) Using Too Much 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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that Yunnan Lincang Xinyuan Germanium Industry Co.,LTD (SZSE:002428) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Yunnan Lincang Xinyuan Germanium IndustryLTD

What Is Yunnan Lincang Xinyuan Germanium IndustryLTD's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2024 Yunnan Lincang Xinyuan Germanium IndustryLTD had debt of CN¥713.6m, up from CN¥658.7m in one year. However, because it has a cash reserve of CN¥218.3m, its net debt is less, at about CN¥495.3m.

How Strong Is Yunnan Lincang Xinyuan Germanium IndustryLTD's Balance Sheet?

According to the last reported balance sheet, Yunnan Lincang Xinyuan Germanium IndustryLTD had liabilities of CN¥741.0m due within 12 months, and liabilities of CN¥616.7m due beyond 12 months. Offsetting this, it had CN¥218.3m in cash and CN¥314.3m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥825.2m.

Since publicly traded Yunnan Lincang Xinyuan Germanium IndustryLTD shares are worth a total of CN¥12.5b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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).

While Yunnan Lincang Xinyuan Germanium IndustryLTD's debt to EBITDA ratio (3.1) suggests that it uses some debt, its interest cover is very weak, at 0.73, suggesting high leverage. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. One redeeming factor for Yunnan Lincang Xinyuan Germanium IndustryLTD is that it turned last year's EBIT loss into a gain of CN¥25m, over the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Yunnan Lincang Xinyuan Germanium IndustryLTD 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, Yunnan Lincang Xinyuan Germanium IndustryLTD 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 Yunnan Lincang Xinyuan Germanium IndustryLTD's interest cover and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But at least it's pretty decent at staying on top of its total liabilities; that's encouraging. Once we consider all the factors above, together, it seems to us that Yunnan Lincang Xinyuan Germanium IndustryLTD's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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. For example, we've discovered 1 warning sign for Yunnan Lincang Xinyuan Germanium IndustryLTD that you should be aware of before investing here.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.