Is China Molybdenum (HKG:3993) Using Too Much 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.' 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, China Molybdenum Co., Ltd. (HKG:3993) does carry debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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, 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 step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for China Molybdenum

What Is China Molybdenum's Net Debt?

The image below, which you can click on for greater detail, shows that at March 2022 China Molybdenum had debt of CN¥59.4b, up from CN¥52.8b in one year. However, it does have CN¥46.8b in cash offsetting this, leading to net debt of about CN¥12.6b.

How Strong Is China Molybdenum's Balance Sheet?

According to the last reported balance sheet, China Molybdenum had liabilities of CN¥73.8b due within 12 months, and liabilities of CN¥43.3b due beyond 12 months. On the other hand, it had cash of CN¥46.8b and CN¥5.14b worth of receivables due within a year. So it has liabilities totalling CN¥65.2b more than its cash and near-term receivables, combined.

This is a mountain of leverage even relative to its gargantuan market capitalization of CN¥97.5b. 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).

China Molybdenum has a low net debt to EBITDA ratio of only 0.64. And its EBIT covers its interest expense a whopping 20.9 times over. So we're pretty relaxed about its super-conservative use of debt. In addition to that, we're happy to report that China Molybdenum has boosted its EBIT by 38%, thus reducing the spectre of future debt repayments. 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 China Molybdenum 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last two years, China Molybdenum recorded negative free cash flow, in total. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Our View

Both China Molybdenum's ability to to cover its interest expense with its EBIT and its EBIT growth rate gave us comfort that it can handle its debt. But truth be told its conversion of EBIT to free cash flow had us nibbling our nails. Looking at all this data makes us feel a little cautious about China Molybdenum's debt levels. 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 1 warning sign for China Molybdenum 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.