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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies Inner Mongolia Baotou Steel Union Co., Ltd. (SHSE:600010) makes use of debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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.

What Is Inner Mongolia Baotou Steel Union's Net Debt?

The image below, which you can click on for greater detail, shows that Inner Mongolia Baotou Steel Union had debt of CN¥40.4b at the end of June 2024, a reduction from CN¥48.1b over a year. However, because it has a cash reserve of CN¥10.5b, its net debt is less, at about CN¥29.9b.

How Healthy Is Inner Mongolia Baotou Steel Union's Balance Sheet?

We can see from the most recent balance sheet that Inner Mongolia Baotou Steel Union had liabilities of CN¥69.8b falling due within a year, and liabilities of CN¥23.6b due beyond that. On the other hand, it had cash of CN¥10.5b and CN¥13.6b worth of receivables due within a year. So it has liabilities totalling CN¥69.3b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of CN¥64.5b, we think shareholders really should watch Inner Mongolia Baotou Steel Union'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 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Inner Mongolia Baotou Steel Union has a debt to EBITDA ratio of 4.6 and its EBIT covered its interest expense 2.9 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. However, it should be some comfort for shareholders to recall that Inner Mongolia Baotou Steel Union actually grew its EBIT by a hefty 198%, over the last 12 months. If it can keep walking that path it will be in a position to shed its debt with relative ease. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Inner Mongolia Baotou Steel Union 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, Inner Mongolia Baotou Steel Union produced sturdy free cash flow equating to 60% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Neither Inner Mongolia Baotou Steel Union's ability handle its debt, based on its EBITDA, nor its level of total liabilities gave us confidence in its ability to take on more debt. But its EBIT growth rate tells a very different story, and suggests some resilience. We think that Inner Mongolia Baotou Steel Union's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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 Inner Mongolia Baotou Steel Union has 2 warning signs (and 1 which is potentially serious) we think you should know about.

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.