Does Metallurgical Corporation of China (HKG:1618) Have A Healthy Balance Sheet?

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.' 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. As with many other companies Metallurgical Corporation of China Ltd. (HKG:1618) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Metallurgical Corporation of China

What Is Metallurgical Corporation of China's Debt?

As you can see below, Metallurgical Corporation of China had CN¥92.9b of debt, at September 2023, which is about the same as the year before. You can click the chart for greater detail. However, because it has a cash reserve of CN¥52.9b, its net debt is less, at about CN¥40.1b.

How Strong Is Metallurgical Corporation of China's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Metallurgical Corporation of China had liabilities of CN¥455.8b due within 12 months and liabilities of CN¥48.2b due beyond that. Offsetting these obligations, it had cash of CN¥52.9b as well as receivables valued at CN¥331.9b due within 12 months. So its liabilities total CN¥119.3b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the CN¥63.7b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. After all, Metallurgical Corporation of China would likely require a major re-capitalisation if it had to pay its creditors today.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Metallurgical Corporation of China's net debt to EBITDA ratio of about 1.5 suggests only moderate use of debt. And its strong interest cover of 19.4 times, makes us even more comfortable. And we also note warmly that Metallurgical Corporation of China grew its EBIT by 14% last year, making its debt load easier to handle. 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 Metallurgical Corporation of China can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Metallurgical Corporation of China's free cash flow amounted to 49% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

Neither Metallurgical Corporation of China's ability to handle its total liabilities nor its conversion of EBIT to free cash flow gave us confidence in its ability to take on more debt. But its interest cover tells a very different story, and suggests some resilience. Taking the abovementioned factors together we do think Metallurgical Corporation of China's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example - Metallurgical Corporation of China has 1 warning sign we think you should be aware of.

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.