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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, Inner Mongolia Baotou Steel Union Co., Ltd. (SHSE:600010) does carry debt. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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.
See our latest analysis for Inner Mongolia Baotou Steel Union
What Is Inner Mongolia Baotou Steel Union's Debt?
As you can see below, at the end of September 2023, Inner Mongolia Baotou Steel Union had CN¥48.6b of debt, up from CN¥36.4b a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥8.45b, its net debt is less, at about CN¥40.1b.
How Healthy Is Inner Mongolia Baotou Steel Union's Balance Sheet?
According to the last reported balance sheet, Inner Mongolia Baotou Steel Union had liabilities of CN¥69.3b due within 12 months, and liabilities of CN¥22.7b due beyond 12 months. Offsetting this, it had CN¥8.45b in cash and CN¥16.7b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥66.9b.
When you consider that this deficiency exceeds the company's CN¥64.9b market capitalization, you might well be inclined to review the balance sheet intently. 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Weak interest cover of 1.4 times and a disturbingly high net debt to EBITDA ratio of 7.0 hit our confidence in Inner Mongolia Baotou Steel Union like a one-two punch to the gut. The debt burden here is substantial. However, it should be some comfort for shareholders to recall that Inner Mongolia Baotou Steel Union actually grew its EBIT by a hefty 8,423%, over the last 12 months. If it can keep walking that path it will be in a position to shed its debt with relative ease. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Inner Mongolia Baotou Steel Union will need earnings to service that debt. 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. Over the last three years, Inner Mongolia Baotou Steel Union actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
Our View
We feel some trepidation about Inner Mongolia Baotou Steel Union's difficulty net debt to EBITDA, but we've got positives to focus on, too. To wit both its conversion of EBIT to free cash flow and EBIT growth rate were encouraging signs. We think that Inner Mongolia Baotou Steel Union's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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 Inner Mongolia Baotou Steel Union (2 don't sit too well with us) you should be aware of.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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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.