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 note that Mingfa Group (International) Company Limited (HKG:846) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

How Much Debt Does Mingfa Group (International) Carry?

The image below, which you can click on for greater detail, shows that Mingfa Group (International) had debt of CN¥10.8b at the end of December 2023, a reduction from CN¥11.5b over a year. However, it also had CN¥1.78b in cash, and so its net debt is CN¥8.98b.

A Look At Mingfa Group (International)'s Liabilities

Zooming in on the latest balance sheet data, we can see that Mingfa Group (International) had liabilities of CN¥46.0b due within 12 months and liabilities of CN¥5.63b due beyond that. Offsetting these obligations, it had cash of CN¥1.78b as well as receivables valued at CN¥2.51b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥47.4b.

The deficiency here weighs heavily on the CN¥1.30b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. At the end of the day, Mingfa Group (International) would probably need a major re-capitalization if its creditors were to demand repayment.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

As it happens Mingfa Group (International) has a fairly concerning net debt to EBITDA ratio of 10.2 but very strong interest coverage of 1k. So either it has access to very cheap long term debt or that interest expense is going to grow! Sadly, Mingfa Group (International)'s EBIT actually dropped 9.5% in the last year. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. When analysing debt levels, the balance sheet is the obvious place to start. But it is Mingfa Group (International)'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 it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Mingfa Group (International) created free cash flow amounting to 10% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

To be frank both Mingfa Group (International)'s net debt to EBITDA and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Taking into account all the aforementioned factors, it looks like Mingfa Group (International) has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 3 warning signs for Mingfa Group (International) that you should be aware of.

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.