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 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. We can see that Inner Mongolia ERDOS Resources Co.,Ltd. (SHSE:900936) does use debt in its business. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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.

See our latest analysis for Inner Mongolia ERDOS ResourcesLtd

What Is Inner Mongolia ERDOS ResourcesLtd's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Inner Mongolia ERDOS ResourcesLtd had CN¥8.77b of debt in December 2022, down from CN¥12.4b, one year before. On the flip side, it has CN¥5.49b in cash leading to net debt of about CN¥3.27b.

How Strong Is Inner Mongolia ERDOS ResourcesLtd's Balance Sheet?

According to the last reported balance sheet, Inner Mongolia ERDOS ResourcesLtd had liabilities of CN¥16.6b due within 12 months, and liabilities of CN¥5.32b due beyond 12 months. Offsetting this, it had CN¥5.49b in cash and CN¥2.06b in receivables that were due within 12 months. So it has liabilities totalling CN¥14.4b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Inner Mongolia ERDOS ResourcesLtd has a market capitalization of CN¥29.5b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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 ERDOS ResourcesLtd has net debt of just 0.33 times EBITDA, suggesting it could ramp leverage without breaking a sweat. And remarkably, despite having net debt, it actually received more in interest over the last twelve months than it had to pay. So it's fair to say it can handle debt like a hotshot teppanyaki chef handles cooking. It is just as well that Inner Mongolia ERDOS ResourcesLtd's load is not too heavy, because its EBIT was down 22% over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. There's no doubt that we learn most about debt from the balance sheet. But it is Inner Mongolia ERDOS ResourcesLtd'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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Inner Mongolia ERDOS ResourcesLtd 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 Inner Mongolia ERDOS ResourcesLtd 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 Inner Mongolia ERDOS ResourcesLtd is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example - Inner Mongolia ERDOS ResourcesLtd has 1 warning sign we think you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.