Here's Why Nan Nan Resources Enterprise (HKG:1229) Has A Meaningful Debt Burden

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 can see that Nan Nan Resources Enterprise Limited (HKG:1229) does use debt in its business. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth 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.

View our latest analysis for Nan Nan Resources Enterprise

What Is Nan Nan Resources Enterprise's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2023 Nan Nan Resources Enterprise had HK$302.8m of debt, an increase on HK$219.8m, over one year. However, it does have HK$234.1m in cash offsetting this, leading to net debt of about HK$68.7m.

How Strong Is Nan Nan Resources Enterprise's Balance Sheet?

The latest balance sheet data shows that Nan Nan Resources Enterprise had liabilities of HK$82.4m due within a year, and liabilities of HK$373.9m falling due after that. Offsetting these obligations, it had cash of HK$234.1m as well as receivables valued at HK$4.24m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$217.9m.

When you consider that this deficiency exceeds the company's HK$166.9m 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.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Nan Nan Resources Enterprise has a low net debt to EBITDA ratio of only 0.65. And its EBIT covers its interest expense a whopping 12.2 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. It is just as well that Nan Nan Resources Enterprise's load is not too heavy, because its EBIT was down 27% over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Nan Nan Resources Enterprise will need earnings to service that debt. 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 clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Nan Nan Resources Enterprise created free cash flow amounting to 16% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

To be frank both Nan Nan Resources Enterprise's level of total liabilities and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Overall, it seems to us that Nan Nan Resources Enterprise's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 3 warning signs for Nan Nan Resources Enterprise (2 don't sit too well with us!) that you should be aware of before investing here.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.