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.' 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 note that Chongyi Zhangyuan Tungsten Co., Ltd. (SZSE:002378) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Chongyi Zhangyuan Tungsten Carry?
As you can see below, at the end of June 2024, Chongyi Zhangyuan Tungsten had CN¥2.08b of debt, up from CN¥1.57b a year ago. Click the image for more detail. However, it also had CN¥373.6m in cash, and so its net debt is CN¥1.70b.
A Look At Chongyi Zhangyuan Tungsten's Liabilities
The latest balance sheet data shows that Chongyi Zhangyuan Tungsten had liabilities of CN¥1.94b due within a year, and liabilities of CN¥928.0m falling due after that. Offsetting these obligations, it had cash of CN¥373.6m as well as receivables valued at CN¥939.8m due within 12 months. So it has liabilities totalling CN¥1.56b more than its cash and near-term receivables, combined.
This deficit isn't so bad because Chongyi Zhangyuan Tungsten is worth CN¥6.88b, 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).
Chongyi Zhangyuan Tungsten has net debt to EBITDA of 3.5 suggesting it uses a fair bit of leverage to boost returns. On the plus side, its EBIT was 8.4 times its interest expense, and its net debt to EBITDA, was quite high, at 3.5. Importantly, Chongyi Zhangyuan Tungsten grew its EBIT by 68% 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 ultimately the future profitability of the business will decide if Chongyi Zhangyuan Tungsten 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Considering the last three years, Chongyi Zhangyuan Tungsten actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.
Our View
When it comes to the balance sheet, the standout positive for Chongyi Zhangyuan Tungsten was the fact that it seems able to grow its EBIT confidently. However, our other observations weren't so heartening. In particular, conversion of EBIT to free cash flow gives us cold feet. When we consider all the factors mentioned above, we do feel a bit cautious about Chongyi Zhangyuan Tungsten's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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. Be aware that Chongyi Zhangyuan Tungsten is showing 2 warning signs in our investment analysis , and 1 of those makes us a bit uncomfortable...
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.
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.