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.' 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 can see that Yanzhou Coal Mining Company Limited (HKG:1171) does use debt in its business. 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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Yanzhou Coal Mining's Debt?
The image below, which you can click on for greater detail, shows that at September 2021 Yanzhou Coal Mining had debt of CN¥104.6b, up from CN¥79.5b in one year. However, because it has a cash reserve of CN¥35.2b, its net debt is less, at about CN¥69.4b.
A Look At Yanzhou Coal Mining's Liabilities
According to the last reported balance sheet, Yanzhou Coal Mining had liabilities of CN¥102.9b due within 12 months, and liabilities of CN¥88.2b due beyond 12 months. Offsetting this, it had CN¥35.2b in cash and CN¥15.8b in receivables that were due within 12 months. So its liabilities total CN¥140.2b more than the combination of its cash and short-term receivables.
Given this deficit is actually higher than the company's massive market capitalization of CN¥94.6b, we think shareholders really should watch Yanzhou Coal Mining'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.
Yanzhou Coal Mining's net debt of 2.0 times EBITDA suggests graceful use of debt. And the fact that its trailing twelve months of EBIT was 8.2 times its interest expenses harmonizes with that theme. Importantly, Yanzhou Coal Mining grew its EBIT by 54% over the last twelve months, and that growth will make it easier to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Yanzhou Coal Mining's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Yanzhou Coal Mining produced sturdy free cash flow equating to 72% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
Yanzhou Coal Mining's EBIT growth rate was a real positive on this analysis, as was its conversion of EBIT to free cash flow. But truth be told its level of total liabilities had us nibbling our nails. When we consider all the factors mentioned above, we do feel a bit cautious about Yanzhou Coal Mining's use of debt. 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. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 5 warning signs for Yanzhou Coal Mining you should be aware of, and 1 of them can't be ignored.
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.
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.
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