David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Yunnan Chihong Zinc & Germanium Co., Ltd. (SHSE:600497) does use debt in its business. But is this debt a concern to shareholders?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth 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 Debt?

The image below, which you can click on for greater detail, shows that Yunnan Chihong Zinc & Germanium had debt of CN¥3.82b at the end of September 2024, a reduction from CN¥4.21b over a year. On the flip side, it has CN¥1.34b in cash leading to net debt of about CN¥2.48b.

A Look At Yunnan Chihong Zinc & Germanium's Liabilities

Zooming in on the latest balance sheet data, we can see that Yunnan Chihong Zinc & Germanium had liabilities of CN¥5.15b due within 12 months and liabilities of CN¥2.49b due beyond that. On the other hand, it had cash of CN¥1.34b and CN¥357.1m worth of receivables due within a year. So its liabilities total CN¥5.95b more than the combination of its cash and short-term receivables.

Yunnan Chihong Zinc & Germanium has a market capitalization of CN¥28.8b, so it could very likely raise cash to ameliorate 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.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Yunnan Chihong Zinc & Germanium's net debt is only 0.85 times its EBITDA. And its EBIT easily covers its interest expense, being 23.5 times the size. So we're pretty relaxed about its super-conservative use of debt. In fact Yunnan Chihong Zinc & Germanium's saving grace is its low debt levels, because its EBIT has tanked 30% in the last twelve months. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. 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 Yunnan Chihong Zinc & Germanium'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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Yunnan Chihong Zinc & Germanium actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

Based on what we've seen Yunnan Chihong Zinc & Germanium is not finding it easy, given its EBIT growth rate, but the other factors we considered give us cause to be optimistic. In particular, we are dazzled with its interest cover. When we consider all the elements mentioned above, it seems to us that Yunnan Chihong Zinc & Germanium is managing its debt quite well. 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. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 1 warning sign for Yunnan Chihong Zinc & Germanium that you should be aware of before investing here.

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.