Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 note that North Copper Co., Ltd. (SZSE:000737) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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 North Copper's Net Debt?

The image below, which you can click on for greater detail, shows that at June 2024 North Copper had debt of CN¥8.24b, up from CN¥3.86b in one year. However, it does have CN¥1.05b in cash offsetting this, leading to net debt of about CN¥7.19b.

How Healthy Is North Copper's Balance Sheet?

According to the last reported balance sheet, North Copper had liabilities of CN¥3.89b due within 12 months, and liabilities of CN¥7.08b due beyond 12 months. On the other hand, it had cash of CN¥1.05b and CN¥278.3m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥9.64b.

This deficit is considerable relative to its market capitalization of CN¥15.2b, so it does suggest shareholders should keep an eye on North Copper's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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.

North Copper's net debt is 4.3 times its EBITDA, which is a significant but still reasonable amount of leverage. However, its interest coverage of 23.9 is very high, suggesting that the interest expense on the debt is currently quite low. Notably, North Copper's EBIT launched higher than Elon Musk, gaining a whopping 126% on last year. When analysing debt levels, the balance sheet is the obvious place to start. But it is North Copper's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

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, North Copper burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

We feel some trepidation about North Copper's difficulty conversion of EBIT to free cash flow, but we've got positives to focus on, too. To wit both its interest cover and EBIT growth rate were encouraging signs. We think that North Copper's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 3 warning signs for North Copper (2 are potentially serious!) that you should be aware of before investing here.

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.