Mongolian Mining (HKG:975) Takes On Some Risk With Its Use Of Debt

Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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. We can see that Mongolian Mining Corporation (HKG:975) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Mongolian Mining

What Is Mongolian Mining's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Mongolian Mining had US$373.8m of debt in December 2022, down from US$452.6m, one year before. On the flip side, it has US$64.7m in cash leading to net debt of about US$309.1m.

A Look At Mongolian Mining's Liabilities

Zooming in on the latest balance sheet data, we can see that Mongolian Mining had liabilities of US$328.3m due within 12 months and liabilities of US$565.1m due beyond that. On the other hand, it had cash of US$64.7m and US$38.3m worth of receivables due within a year. So its liabilities total US$790.4m more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the US$432.9m company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. At the end of the day, Mongolian Mining would probably need a major re-capitalization if its creditors were to demand repayment.

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

While Mongolian Mining has a quite reasonable net debt to EBITDA multiple of 2.3, its interest cover seems weak, at 1.6. This does suggest the company is paying fairly high interest rates. In any case, it's safe to say the company has meaningful debt. We also note that Mongolian Mining improved its EBIT from a last year's loss to a positive US$70m. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Mongolian Mining will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Happily for any shareholders, Mongolian Mining actually produced more free cash flow than EBIT over the last year. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

To be frank both Mongolian Mining's interest cover and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Looking at the bigger picture, it seems clear to us that Mongolian Mining's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. We've identified 3 warning signs with Mongolian Mining (at least 1 which shouldn't be ignored) , 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.