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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Huaibei Mining Holdings Co.,Ltd. (SHSE:600985) does use debt in its business. But should shareholders be worried about its use of debt?

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. 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, 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.

How Much Debt Does Huaibei Mining HoldingsLtd Carry?

The image below, which you can click on for greater detail, shows that Huaibei Mining HoldingsLtd had debt of CN¥8.97b at the end of December 2023, a reduction from CN¥13.2b over a year. However, it does have CN¥8.65b in cash offsetting this, leading to net debt of about CN¥315.2m.

A Look At Huaibei Mining HoldingsLtd's Liabilities

The latest balance sheet data shows that Huaibei Mining HoldingsLtd had liabilities of CN¥27.3b due within a year, and liabilities of CN¥18.1b falling due after that. On the other hand, it had cash of CN¥8.65b and CN¥6.12b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥30.7b.

This deficit isn't so bad because Huaibei Mining HoldingsLtd is worth CN¥51.2b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. Carrying virtually no net debt, Huaibei Mining HoldingsLtd has a very light debt load indeed.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (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).

Huaibei Mining HoldingsLtd has very little debt (net of cash), and boasts a debt to EBITDA ratio of 0.027 and EBIT of 16.1 times the interest expense. Indeed relative to its earnings its debt load seems light as a feather. On the other hand, Huaibei Mining HoldingsLtd's EBIT dived 19%, over the last year. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. 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 Huaibei Mining HoldingsLtd can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Huaibei Mining HoldingsLtd generated free cash flow amounting to a very robust 89% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Our View

Huaibei Mining HoldingsLtd's interest cover was a real positive on this analysis, as was its conversion of EBIT to free cash flow. In contrast, our confidence was undermined by its apparent struggle to grow its EBIT. Considering this range of data points, we think Huaibei Mining HoldingsLtd is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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 instance, we've identified 2 warning signs for Huaibei Mining HoldingsLtd that you should be aware of.

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.

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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.