Chongqing Iron & Steel (HKG:1053) Has A Pretty Healthy Balance Sheet

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Chongqing Iron & Steel Company Limited (HKG:1053) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Chongqing Iron & Steel

What Is Chongqing Iron & Steel's Debt?

As you can see below, Chongqing Iron & Steel had CN¥4.20b of debt at March 2021, down from CN¥4.83b a year prior. However, because it has a cash reserve of CN¥3.67b, its net debt is less, at about CN¥522.9m.

How Healthy Is Chongqing Iron & Steel's Balance Sheet?

We can see from the most recent balance sheet that Chongqing Iron & Steel had liabilities of CN¥13.2b falling due within a year, and liabilities of CN¥7.77b due beyond that. Offsetting this, it had CN¥3.67b in cash and CN¥2.39b in receivables that were due within 12 months. So its liabilities total CN¥14.9b more than the combination of its cash and short-term receivables.

Chongqing Iron & Steel has a market capitalization of CN¥25.3b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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).

Chongqing Iron & Steel has net debt of just 0.18 times EBITDA, indicating that it is certainly not a reckless borrower. And this view is supported by the solid interest coverage, with EBIT coming in at 9.9 times the interest expense over the last year. Even more impressive was the fact that Chongqing Iron & Steel grew its EBIT by 173% over twelve months. If maintained that growth will make the debt even more manageable in the years ahead. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Chongqing Iron & Steel's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Chongqing Iron & Steel reported free cash flow worth 20% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

Both Chongqing Iron & Steel's ability to to grow its EBIT and its net debt to EBITDA gave us comfort that it can handle its debt. On the other hand, its conversion of EBIT to free cash flow makes us a little less comfortable about its debt. When we consider all the elements mentioned above, it seems to us that Chongqing Iron & Steel is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Chongqing Iron & Steel you should know about.

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. 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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