Here's Why China Steel (TWSE:2002) Has A Meaningful Debt Burden

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 note that China Steel Corporation (TWSE:2002) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for China Steel

What Is China Steel's Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2024 China Steel had NT$259.1b of debt, an increase on NT$236.2b, over one year. On the flip side, it has NT$43.6b in cash leading to net debt of about NT$215.5b.

How Strong Is China Steel's Balance Sheet?

The latest balance sheet data shows that China Steel had liabilities of NT$164.2b due within a year, and liabilities of NT$185.7b falling due after that. Offsetting this, it had NT$43.6b in cash and NT$23.9b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$282.5b.

This is a mountain of leverage even relative to its gargantuan market capitalization of NT$324.0b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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).

As it happens China Steel has a fairly concerning net debt to EBITDA ratio of 6.3 but very strong interest coverage of 1k. So either it has access to very cheap long term debt or that interest expense is going to grow! We also note that China Steel improved its EBIT from a last year's loss to a positive NT$4.2b. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine China Steel's ability to maintain a healthy balance sheet going forward. 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 the earnings before interest and tax (EBIT) is backed by free cash flow. In the last year, China Steel created free cash flow amounting to 19% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

Mulling over China Steel's attempt at managing its debt, based on its EBITDA,, we're certainly not enthusiastic. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Once we consider all the factors above, together, it seems to us that China Steel's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 1 warning sign for China Steel that you should be aware of before investing here.

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.