Is Chongqing Iron & Steel (HKG:1053) Using Debt Sensibly?

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. As with many other companies Chongqing Iron & Steel Company Limited (HKG:1053) makes use of debt. But the more important question is: how much risk is that debt creating?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest 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 Chongqing Iron & Steel

What Is Chongqing Iron & Steel's Net Debt?

The chart below, which you can click on for greater detail, shows that Chongqing Iron & Steel had CN¥5.50b in debt in December 2022; about the same as the year before. However, because it has a cash reserve of CN¥4.00b, its net debt is less, at about CN¥1.51b.

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¥13.1b falling due within a year, and liabilities of CN¥4.96b due beyond that. Offsetting this, it had CN¥4.00b in cash and CN¥873.3m in receivables that were due within 12 months. So it has liabilities totalling CN¥13.2b more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of CN¥13.6b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Chongqing Iron & Steel 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.

In the last year Chongqing Iron & Steel had a loss before interest and tax, and actually shrunk its revenue by 8.3%, to CN¥37b. We would much prefer see growth.

Caveat Emptor

Importantly, Chongqing Iron & Steel had an earnings before interest and tax (EBIT) loss over the last year. Indeed, it lost CN¥798m at the EBIT level. Considering that alongside the liabilities mentioned above does not give us much confidence that company should be using so much debt. Quite frankly we think the balance sheet is far from match-fit, although it could be improved with time. However, it doesn't help that it burned through CN¥1.2b of cash over the last year. So suffice it to say we consider the stock very risky. 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. For example, we've discovered 1 warning sign for Chongqing Iron & Steel that you should be aware of before investing here.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.