Here's Why Zhaojin Mining Industry (HKG:1818) Can Manage Its Debt Responsibly

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.' 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. Importantly, Zhaojin Mining Industry Company Limited (HKG:1818) does carry debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Zhaojin Mining Industry

What Is Zhaojin Mining Industry's Debt?

As you can see below, Zhaojin Mining Industry had CN¥15.0b of debt, at September 2022, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has CN¥5.37b in cash leading to net debt of about CN¥9.61b.

How Healthy Is Zhaojin Mining Industry's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Zhaojin Mining Industry had liabilities of CN¥17.5b due within 12 months and liabilities of CN¥9.28b due beyond that. On the other hand, it had cash of CN¥5.37b and CN¥1.66b worth of receivables due within a year. So its liabilities total CN¥19.7b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of CN¥25.0b, so it does suggest shareholders should keep an eye on Zhaojin Mining Industry's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). 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).

Zhaojin Mining Industry's net debt to EBITDA ratio is 5.5 which suggests rather high debt levels, but its interest cover of 8.5 times suggests the debt is easily serviced. Our best guess is that the company does indeed have significant debt obligations. We note that Zhaojin Mining Industry grew its EBIT by 20% 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 it is future earnings, more than anything, that will determine Zhaojin Mining Industry's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

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. Over the most recent three years, Zhaojin Mining Industry recorded free cash flow worth 59% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

Zhaojin Mining Industry's net debt to EBITDA was a real negative on this analysis, although the other factors we considered were considerably better. There's no doubt that its ability to to grow its EBIT is pretty flash. When we consider all the factors mentioned above, we do feel a bit cautious about Zhaojin Mining Industry'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. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Zhaojin Mining Industry (of which 1 is concerning!) you should know about.

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.

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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.