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.' 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. We note that Yunnan Copper Co.,Ltd (SZSE:000878) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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. When we think about a company's use of debt, we first look at cash and debt together.

What Is Yunnan CopperLtd's Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2024 Yunnan CopperLtd had CN¥23.1b of debt, an increase on CN¥13.2b, over one year. However, because it has a cash reserve of CN¥8.61b, its net debt is less, at about CN¥14.5b.

How Strong Is Yunnan CopperLtd's Balance Sheet?

The latest balance sheet data shows that Yunnan CopperLtd had liabilities of CN¥25.5b due within a year, and liabilities of CN¥9.82b falling due after that. On the other hand, it had cash of CN¥8.61b and CN¥941.4m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥25.8b.

Given this deficit is actually higher than the company's market capitalization of CN¥21.8b, we think shareholders really should watch Yunnan CopperLtd's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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

Yunnan CopperLtd's net debt is 2.8 times its EBITDA, which is a significant but still reasonable amount of leverage. However, its interest coverage of 22.7 is very high, suggesting that the interest expense on the debt is currently quite low. Importantly Yunnan CopperLtd's EBIT was essentially flat over the last twelve months. We would prefer to see some earnings growth, because that always helps diminish 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 Yunnan CopperLtd can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Yunnan CopperLtd actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

While Yunnan CopperLtd's level of total liabilities has us nervous. For example, its interest cover and conversion of EBIT to free cash flow give us some confidence in its ability to manage its debt. Looking at all the angles mentioned above, it does seem to us that Yunnan CopperLtd is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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 Yunnan CopperLtd has 2 warning signs (and 1 which is a bit concerning) we think you should know about.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.