The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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. Importantly, Yunnan Chihong Zinc & Germanium Co., Ltd. (SHSE:600497) does carry debt. But the real question is whether this debt is making the company risky.

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. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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 step when considering a company's debt levels is to consider its cash and debt together.

What Is Yunnan Chihong Zinc & Germanium's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Yunnan Chihong Zinc & Germanium had CN¥4.34b of debt in March 2024, down from CN¥5.46b, one year before. On the flip side, it has CN¥1.30b in cash leading to net debt of about CN¥3.03b.

How Healthy Is Yunnan Chihong Zinc & Germanium's Balance Sheet?

According to the last reported balance sheet, Yunnan Chihong Zinc & Germanium had liabilities of CN¥4.49b due within 12 months, and liabilities of CN¥4.01b due beyond 12 months. Offsetting this, it had CN¥1.30b in cash and CN¥307.9m in receivables that were due within 12 months. So it has liabilities totalling CN¥6.90b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Yunnan Chihong Zinc & Germanium is worth CN¥28.9b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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).

Yunnan Chihong Zinc & Germanium has a low net debt to EBITDA ratio of only 0.99. And its EBIT covers its interest expense a whopping 22.1 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. But the bad news is that Yunnan Chihong Zinc & Germanium has seen its EBIT plunge 18% in the last twelve months. If that rate of decline in earnings continues, the company could find itself in a tight spot. 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 Yunnan Chihong Zinc & Germanium 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.

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. Happily for any shareholders, Yunnan Chihong Zinc & Germanium actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

Both Yunnan Chihong Zinc & Germanium's ability to to cover its interest expense with its EBIT and its conversion of EBIT to free cash flow gave us comfort that it can handle its debt. But truth be told its EBIT growth rate had us nibbling our nails. Considering this range of data points, we think Yunnan Chihong Zinc & Germanium 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 instance, we've identified 1 warning sign for Yunnan Chihong Zinc & Germanium that 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.

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