Here's Why Hunan SilverLtd (SZSE:002716) Can Manage Its Debt Responsibly

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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, Hunan Silver Co.,Ltd. (SZSE:002716) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Hunan SilverLtd

What Is Hunan SilverLtd's Net Debt?

As you can see below, at the end of September 2024, Hunan SilverLtd had CN¥764.1m of debt, up from CN¥691.8m a year ago. Click the image for more detail. However, it does have CN¥446.3m in cash offsetting this, leading to net debt of about CN¥317.8m.

How Strong Is Hunan SilverLtd's Balance Sheet?

The latest balance sheet data shows that Hunan SilverLtd had liabilities of CN¥1.91b due within a year, and liabilities of CN¥950.0m falling due after that. Offsetting this, it had CN¥446.3m in cash and CN¥28.3m in receivables that were due within 12 months. So it has liabilities totalling CN¥2.39b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Hunan SilverLtd has a market capitalization of CN¥10.4b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

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).

While Hunan SilverLtd has a quite reasonable net debt to EBITDA multiple of 1.9, its interest cover seems weak, at 0.61. The main reason for this is that it has such high depreciation and amortisation. These charges may be non-cash, so they could be excluded when it comes to paying down debt. But the accounting charges are there for a reason -- some assets are seen to be losing value. Either way there's no doubt the stock is using meaningful leverage. Pleasingly, Hunan SilverLtd is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 372% gain in the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Hunan SilverLtd will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last two years, Hunan SilverLtd actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

Happily, Hunan SilverLtd's impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. But we must concede we find its interest cover has the opposite effect. When we consider the range of factors above, it looks like Hunan SilverLtd is pretty sensible with its use of debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example - Hunan SilverLtd has 1 warning sign we think you should be aware of.

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.