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. As with many other companies Inner Mongolia Yitai Coal Co., Ltd. (SHSE:900948) makes use of debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, 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.

Check out our latest analysis for Inner Mongolia Yitai Coal

How Much Debt Does Inner Mongolia Yitai Coal Carry?

The image below, which you can click on for greater detail, shows that Inner Mongolia Yitai Coal had debt of CN¥25.1b at the end of March 2022, a reduction from CN¥35.0b over a year. However, it also had CN¥18.0b in cash, and so its net debt is CN¥7.07b.

A Look At Inner Mongolia Yitai Coal's Liabilities

Zooming in on the latest balance sheet data, we can see that Inner Mongolia Yitai Coal had liabilities of CN¥15.8b due within 12 months and liabilities of CN¥23.2b due beyond that. On the other hand, it had cash of CN¥18.0b and CN¥4.01b worth of receivables due within a year. So it has liabilities totalling CN¥17.1b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Inner Mongolia Yitai Coal has a market capitalization of CN¥34.7b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

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.

Inner Mongolia Yitai Coal's net debt is only 0.37 times its EBITDA. And its EBIT easily covers its interest expense, being 29.3 times the size. So we're pretty relaxed about its super-conservative use of debt. Better yet, Inner Mongolia Yitai Coal grew its EBIT by 240% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. When analysing debt levels, the balance sheet is the obvious place to start. But it is Inner Mongolia Yitai Coal's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

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. Over the last three years, Inner Mongolia Yitai Coal actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

Inner Mongolia Yitai Coal's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But truth be told we feel its level of total liabilities does undermine this impression a bit. Zooming out, Inner Mongolia Yitai Coal seems to use debt quite reasonably; and that gets the nod from us. While debt does bring risk, when used wisely it can also bring a higher return on equity. 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. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Inner Mongolia Yitai Coal you should know about.

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.