We Think Chongqing Iron & Steel (HKG:1053) Can Stay On Top Of Its Debt

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 note that Chongqing Iron & Steel Company Limited (HKG:1053) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Chongqing Iron & Steel

What Is Chongqing Iron & Steel's Net Debt?

As you can see below, Chongqing Iron & Steel had CN¥4.38b of debt at March 2022, down from CN¥5.27b a year prior. However, because it has a cash reserve of CN¥4.09b, its net debt is less, at about CN¥290.0m.

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

Zooming in on the latest balance sheet data, we can see that Chongqing Iron & Steel had liabilities of CN¥15.7b due within 12 months and liabilities of CN¥3.89b due beyond that. Offsetting these obligations, it had cash of CN¥4.09b as well as receivables valued at CN¥3.29b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥12.2b.

This is a mountain of leverage relative to its market capitalization of CN¥14.9b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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 very modest net debt, giving rise to a debt to EBITDA ratio of 0.071. And EBIT easily covered the interest expense 7.4 times over, lending force to that view. Also positive, Chongqing Iron & Steel grew its EBIT by 27% in the last year, and that should make it easier to pay down debt, going forward. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Chongqing Iron & Steel will need earnings to service that debt. 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 18% 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 handle its debt, based on its EBITDA, and its EBIT growth rate gave us comfort that it can handle its debt. Having said that, its conversion of EBIT to free cash flow somewhat sensitizes us to potential future risks to the balance sheet. When we consider all the factors mentioned above, we do feel a bit cautious about Chongqing Iron & Steel's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of Chongqing Iron & Steel's earnings per share history for free.

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.

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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.