Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Nanjing Iron & Steel Co., Ltd. (SHSE:600282) does carry debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. If things get really bad, the lenders can take control of the business. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

What Is Nanjing Iron & Steel's Net Debt?

The image below, which you can click on for greater detail, shows that Nanjing Iron & Steel had debt of CN¥22.3b at the end of June 2024, a reduction from CN¥25.0b over a year. However, because it has a cash reserve of CN¥6.33b, its net debt is less, at about CN¥16.0b.

How Strong Is Nanjing Iron & Steel's Balance Sheet?

According to the last reported balance sheet, Nanjing Iron & Steel had liabilities of CN¥32.2b due within 12 months, and liabilities of CN¥9.84b due beyond 12 months. On the other hand, it had cash of CN¥6.33b and CN¥10.7b worth of receivables due within a year. So it has liabilities totalling CN¥25.0b more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of CN¥26.3b. 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).

With net debt to EBITDA of 2.8 Nanjing Iron & Steel has a fairly noticeable amount of debt. But the high interest coverage of 8.0 suggests it can easily service that debt. Importantly, Nanjing Iron & Steel grew its EBIT by 35% over the last twelve months, and that growth will make it easier to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Nanjing Iron & 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Nanjing Iron & Steel 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

Nanjing Iron & Steel's conversion of EBIT to free cash flow and level of total liabilities definitely weigh on it, in our esteem. But its EBIT growth rate tells a very different story, and suggests some resilience. When we consider all the factors discussed, it seems to us that Nanjing Iron & Steel is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 2 warning signs for Nanjing Iron & Steel you should be aware of, and 1 of them is a bit unpleasant.

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.