We Think Metallurgical Corporation of China (HKG:1618) Can Stay On Top Of Its 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. 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?

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. 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. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Metallurgical Corporation of China

What Is Metallurgical Corporation of China's Net Debt?

The chart below, which you can click on for greater detail, shows that Metallurgical Corporation of China had CN¥88.9b in debt in March 2023; about the same as the year before. On the flip side, it has CN¥58.0b in cash leading to net debt of about CN¥30.8b.

A Look At Metallurgical Corporation of China's Liabilities

Zooming in on the latest balance sheet data, we can see that Metallurgical Corporation of China had liabilities of CN¥411.9b due within 12 months and liabilities of CN¥47.6b due beyond that. On the other hand, it had cash of CN¥58.0b and CN¥296.1b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥105.3b.

When you consider that this deficiency exceeds the company's huge CN¥86.0b market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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).

Metallurgical Corporation of China's net debt is only 1.3 times its EBITDA. And its EBIT covers its interest expense a whopping 192 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Fortunately, Metallurgical Corporation of China grew its EBIT by 5.3% in the last year, making that debt load look even more manageable. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Metallurgical Corporation of China'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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Metallurgical Corporation of China produced sturdy free cash flow equating to 68% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

When it comes to the balance sheet, the standout positive for Metallurgical Corporation of China was the fact that it seems able to cover its interest expense with its EBIT confidently. But the other factors we noted above weren't so encouraging. To be specific, it seems about as good at staying on top of its total liabilities as wet socks are at keeping your feet warm. Looking at all this data makes us feel a little cautious about Metallurgical Corporation of China's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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, we've discovered 1 warning sign for Metallurgical Corporation of China that you should be aware of before investing here.

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.