Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 note that Chengtun Mining Group Co., Ltd. (SHSE:600711) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. 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 Chengtun Mining Group Carry?

The image below, which you can click on for greater detail, shows that at March 2024 Chengtun Mining Group had debt of CN¥12.4b, up from CN¥6.69b in one year. However, because it has a cash reserve of CN¥6.20b, its net debt is less, at about CN¥6.21b.

How Healthy Is Chengtun Mining Group's Balance Sheet?

We can see from the most recent balance sheet that Chengtun Mining Group had liabilities of CN¥16.1b falling due within a year, and liabilities of CN¥6.22b due beyond that. Offsetting these obligations, it had cash of CN¥6.20b as well as receivables valued at CN¥2.17b due within 12 months. So its liabilities total CN¥13.9b more than the combination of its cash and short-term receivables.

Given this deficit is actually higher than the company's market capitalization of CN¥13.2b, we think shareholders really should watch Chengtun Mining Group's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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).

Chengtun Mining Group has net debt worth 2.5 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 2.9 times the interest expense. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. Pleasingly, Chengtun Mining Group is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 187% gain in the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But it is Chengtun Mining Group's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Chengtun Mining Group burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

We'd go so far as to say Chengtun Mining Group's conversion of EBIT to free cash flow was disappointing. But at least it's pretty decent at growing its EBIT; that's encouraging. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Chengtun Mining Group stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. The balance sheet is clearly the area to focus on when you are analysing debt. 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 2 warning signs for Chengtun Mining Group (of which 1 makes us a bit uncomfortable!) you should know about.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.