Is Hunan SilverLtd (SZSE:002716) Using Too Much Debt?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. As with many other companies Hunan Silver Co.,Ltd. (SZSE:002716) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Hunan SilverLtd

What Is Hunan SilverLtd's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2024 Hunan SilverLtd had debt of CN¥764.1m, up from CN¥691.8m in one year. On the flip side, it has CN¥446.3m in cash leading to net debt of about CN¥317.8m.

How Strong Is Hunan SilverLtd's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Hunan SilverLtd had liabilities of CN¥1.91b due within 12 months and liabilities of CN¥950.0m due beyond that. On the other hand, it had cash of CN¥446.3m and CN¥28.3m worth of receivables due within a year. So its liabilities total CN¥2.39b more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Hunan SilverLtd is worth CN¥10.6b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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 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. While companies often boast that these charges are non-cash, most such businesses will therefore require ongoing investment (that is not expensed.) Either way there's no doubt the stock is using meaningful leverage. Notably, Hunan SilverLtd's EBIT launched higher than Elon Musk, gaining a whopping 372% on last year. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Hunan SilverLtd's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into 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 the stark truth is that we are concerned by its interest cover. When we consider the range of factors above, it looks like Hunan SilverLtd is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. Even though Hunan SilverLtd lost money on the bottom line, its positive EBIT suggests the business itself has potential. So you might want to check out how earnings have been trending over the last few years.

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.