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 Zhaojin Mining Industry Company Limited (HKG:1818) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Zhaojin Mining Industry

What Is Zhaojin Mining Industry's Debt?

You can click the graphic below for the historical numbers, but it shows that Zhaojin Mining Industry had CN¥13.2b of debt in March 2022, down from CN¥15.9b, one year before. On the flip side, it has CN¥6.90b in cash leading to net debt of about CN¥6.31b.

How Healthy Is Zhaojin Mining Industry's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Zhaojin Mining Industry had liabilities of CN¥18.1b due within 12 months and liabilities of CN¥8.23b due beyond that. Offsetting these obligations, it had cash of CN¥6.90b as well as receivables valued at CN¥1.04b due within 12 months. So it has liabilities totalling CN¥18.4b more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of CN¥19.5b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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.

While we wouldn't worry about Zhaojin Mining Industry's net debt to EBITDA ratio of 3.6, we think its super-low interest cover of 2.4 times is a sign of high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Worse, Zhaojin Mining Industry's EBIT was down 50% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Zhaojin Mining Industry's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

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 most recent three years, Zhaojin Mining Industry recorded free cash flow worth 66% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

We'd go so far as to say Zhaojin Mining Industry's EBIT growth rate was disappointing. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Overall, we think it's fair to say that Zhaojin Mining Industry has enough debt that there are some real risks around the balance sheet. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. 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. Case in point: We've spotted 3 warning signs for Zhaojin Mining Industry you should be aware of.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.