These 4 Measures Indicate That China Molybdenum (HKG:3993) Is Using Debt Reasonably Well

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 China Molybdenum Co., Ltd. (HKG:3993) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for China Molybdenum

What Is China Molybdenum's Net Debt?

As you can see below, at the end of September 2021, China Molybdenum had CN¥52.9b of debt, up from CN¥47.2b a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥37.4b, its net debt is less, at about CN¥15.4b.

How Strong Is China Molybdenum's Balance Sheet?

The latest balance sheet data shows that China Molybdenum had liabilities of CN¥55.4b due within a year, and liabilities of CN¥38.2b falling due after that. Offsetting these obligations, it had cash of CN¥37.4b as well as receivables valued at CN¥3.69b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥52.4b.

While this might seem like a lot, it is not so bad since China Molybdenum has a huge market capitalization of CN¥116.5b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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 0.92. And its EBIT easily covers its interest expense, being 16.7 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Even more impressive was the fact that China Molybdenum grew its EBIT by 461% over twelve months. If maintained that growth will make the debt even more manageable in the years ahead. 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three 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

China Molybdenum's interest cover was a real positive on this analysis, as was its EBIT growth rate. In contrast, our confidence was undermined by its apparent struggle to convert EBIT to free cash flow. Considering this range of data points, we think China Molybdenum is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. 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. For example - China Molybdenum has 1 warning sign we think you should be aware of.

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.