Anhui Honglu Steel Construction(Group) (SZSE:002541) Use Of Debt Could Be Considered Risky

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. Importantly, Anhui Honglu Steel Construction(Group) CO., LTD (SZSE:002541) does carry debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Anhui Honglu Steel Construction(Group)

How Much Debt Does Anhui Honglu Steel Construction(Group) Carry?

As you can see below, at the end of September 2024, Anhui Honglu Steel Construction(Group) had CN¥9.38b of debt, up from CN¥7.55b a year ago. Click the image for more detail. On the flip side, it has CN¥2.26b in cash leading to net debt of about CN¥7.12b.

How Strong Is Anhui Honglu Steel Construction(Group)'s Balance Sheet?

According to the last reported balance sheet, Anhui Honglu Steel Construction(Group) had liabilities of CN¥9.59b due within 12 months, and liabilities of CN¥6.45b due beyond 12 months. Offsetting this, it had CN¥2.26b in cash and CN¥3.77b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥10.0b.

This deficit is considerable relative to its market capitalization of CN¥11.2b, so it does suggest shareholders should keep an eye on Anhui Honglu Steel Construction(Group)'s use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). 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).

Weak interest cover of 2.3 times and a disturbingly high net debt to EBITDA ratio of 5.4 hit our confidence in Anhui Honglu Steel Construction(Group) like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Even worse, Anhui Honglu Steel Construction(Group) saw its EBIT tank 51% over the last 12 months. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Anhui Honglu Steel Construction(Group)'s ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Anhui Honglu Steel Construction(Group) burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both Anhui Honglu Steel Construction(Group)'s conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. And furthermore, its interest cover also fails to instill confidence. After considering the datapoints discussed, we think Anhui Honglu Steel Construction(Group) has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 3 warning signs for Anhui Honglu Steel Construction(Group) you should be aware of, and 1 of them doesn't sit too well with us.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.