Xinjiang Xinxin Mining Industry (HKG:3833) Takes On Some Risk With Its Use Of Debt

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Xinjiang Xinxin Mining Industry Co., Ltd. (HKG:3833) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Xinjiang Xinxin Mining Industry

How Much Debt Does Xinjiang Xinxin Mining Industry Carry?

You can click the graphic below for the historical numbers, but it shows that Xinjiang Xinxin Mining Industry had CN¥1.85b of debt in June 2020, down from CN¥2.28b, one year before. However, because it has a cash reserve of CN¥357.7m, its net debt is less, at about CN¥1.50b.

A Look At Xinjiang Xinxin Mining Industry's Liabilities

Zooming in on the latest balance sheet data, we can see that Xinjiang Xinxin Mining Industry had liabilities of CN¥2.01b due within 12 months and liabilities of CN¥1.46b due beyond that. On the other hand, it had cash of CN¥357.7m and CN¥342.7m worth of receivables due within a year. So its liabilities total CN¥2.77b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the CN¥1.03b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Xinjiang Xinxin Mining Industry would likely require a major re-capitalisation if it had to pay its creditors today.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While we wouldn't worry about Xinjiang Xinxin Mining Industry's net debt to EBITDA ratio of 4.5, we think its super-low interest cover of 1.4 times is a sign of high leverage. In large part that's due to the company's significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. However, it should be some comfort for shareholders to recall that Xinjiang Xinxin Mining Industry actually grew its EBIT by a hefty 194%, over the last 12 months. If it can keep walking that path it will be in a position to shed its debt with relative ease. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Xinjiang Xinxin Mining Industry 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 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. Over the last three years, Xinjiang Xinxin Mining Industry actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

While Xinjiang Xinxin Mining Industry's level of total liabilities has us nervous. To wit both its conversion of EBIT to free cash flow and EBIT growth rate were encouraging signs. Taking the abovementioned factors together we do think Xinjiang Xinxin Mining Industry's debt poses some risks to the business. 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. However, not all investment risk resides within the balance sheet - far from it. Consider for instance, the ever-present spectre of investment risk. We've identified 2 warning signs with Xinjiang Xinxin Mining Industry (at least 1 which is a bit concerning) , and understanding them should be part of your investment process.

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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