Here's Why Metallurgical Corporation of China (HKG:1618) Can Manage Its Debt Responsibly

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.' 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. We note that Metallurgical Corporation of China Ltd. (HKG:1618) does have debt on its balance sheet. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Metallurgical Corporation of China

What Is Metallurgical Corporation of China's Debt?

As you can see below, at the end of September 2022, Metallurgical Corporation of China had CN¥92.4b of debt, up from CN¥83.1b a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥57.2b, its net debt is less, at about CN¥35.2b.

How Healthy 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¥428.4b due within 12 months and liabilities of CN¥44.6b due beyond that. Offsetting these obligations, it had cash of CN¥57.2b as well as receivables valued at CN¥346.9b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥69.0b.

Given this deficit is actually higher than the company's market capitalization of CN¥63.6b, we think shareholders really should watch Metallurgical Corporation of China's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Metallurgical Corporation of China's net debt to EBITDA ratio of about 1.6 suggests only moderate use of debt. And its strong interest cover of 1k times, makes us even more comfortable. The good news is that Metallurgical Corporation of China has increased its EBIT by 6.1% over twelve months, which should ease any concerns about debt repayment. 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 Metallurgical Corporation of China 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Happily for any shareholders, Metallurgical Corporation of China actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

Both Metallurgical Corporation of China's ability to to cover its interest expense with its EBIT and its conversion of EBIT to free cash flow gave us comfort that it can handle its debt. In contrast, our confidence was undermined by its apparent struggle to handle its total liabilities. When we consider all the elements mentioned above, it seems to us that Metallurgical Corporation of China is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Metallurgical Corporation of China you should know about.

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.