Is Zhaojin Mining Industry (HKG:1818) Using Too Much Debt?

Warren Buffett famously said, '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 can see that Zhaojin Mining Industry Company Limited (HKG:1818) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Zhaojin Mining Industry

How Much Debt Does Zhaojin Mining Industry Carry?

As you can see below, Zhaojin Mining Industry had CN¥19.1b of debt at June 2021, down from CN¥21.2b a year prior. However, it does have CN¥3.18b in cash offsetting this, leading to net debt of about CN¥16.0b.

A Look At Zhaojin Mining Industry's Liabilities

The latest balance sheet data shows that Zhaojin Mining Industry had liabilities of CN¥16.5b due within a year, and liabilities of CN¥6.86b falling due after that. Offsetting these obligations, it had cash of CN¥3.18b as well as receivables valued at CN¥2.22b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥18.0b.

Given this deficit is actually higher than the company's market capitalization of CN¥16.0b, we think shareholders really should watch Zhaojin Mining Industry's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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).

Zhaojin Mining Industry has a rather high debt to EBITDA ratio of 5.7 which suggests a meaningful debt load. However, its interest coverage of 3.7 is reasonably strong, which is a good sign. The good news is that Zhaojin Mining Industry grew its EBIT a smooth 39% over the last twelve months. Like the milk of human kindness that sort of growth increases resilience, making the company more capable of managing debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Zhaojin Mining Industry can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Zhaojin Mining Industry's free cash flow amounted to 44% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Neither Zhaojin Mining Industry's ability handle its debt, based on its EBITDA, nor its level of total liabilities gave us confidence in its ability to take on more debt. But the good news is it seems to be able to grow its EBIT with ease. When we consider all the factors discussed, it seems to us that Zhaojin Mining Industry is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. 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. We've identified 3 warning signs with Zhaojin Mining Industry (at least 1 which doesn't sit too well with us) , and understanding them should be part of your investment process.

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. 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.
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