Is China Molybdenum (HKG:3993) using too much debt?

Berkshire Hathaway’s Charlie Munger-backed outside fund manager Li Lu is quick to say, “The biggest risk in investing isn’t price volatility, but whether you’re going to suffer a permanent loss of capital “. When we think of a company’s risk, we always like to look at its use of debt, because over-indebtedness can lead to ruin. Above all, China Molybdenum Co., Ltd. (HKG:3993) is in debt. But the more important question is: what risk does this debt create?

Why is debt risky?

Generally speaking, debt only becomes a real problem when a company cannot easily repay it, either by raising capital or with its own cash flow. Ultimately, if the company cannot meet its legal debt repayment obligations, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity at a low price, thereby permanently diluting shareholders. Of course, the advantage of debt is that it often represents cheap capital, especially when it replaces dilution in a business with the ability to reinvest at high rates of return. The first step when considering a company’s debt levels is to consider its cash and debt together.

Check out our latest analysis for molybdenum from China

What is China Molybdenum’s net debt?

The image below, which you can click on for more details, shows that in March 2022, China Molybdenum had a debt of 59.4 billion Canadian yen, compared to 52.8 billion Canadian yen in one year. However, it has 46.8 billion national yen of cash to offset this, resulting in a net debt of approximately 12.6 billion national yen.

SEHK: 3993 Historical Debt to Equity June 3, 2022

How strong is China Molybdenum’s balance sheet?

According to the latest published balance sheet, China Molybdenum had liabilities of 73.8 billion Canadian yen due within 12 months and liabilities of 43.3 billion domestic yen due beyond 12 months. On the other hand, it had a cash position of 46.8 billion Canadian yen and 5.14 billion national yen of receivables due within one year. It therefore has liabilities totaling 65.2 billion Canadian yen more than its cash and short-term receivables, combined.

This is a mountain of leverage, even compared to its gargantuan market capitalization of 97.5 billion Canadian yen. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet quickly.

We use two main ratios to inform us about debt to earnings levels. The first is net debt divided by earnings before interest, taxes, depreciation and amortization (EBITDA), while the second is how often its earnings before interest and taxes (EBIT) covers its interest expense (or its interests, for short). The advantage of this approach is that we consider both the absolute amount of debt (with net debt to EBITDA) and the actual interest expense associated with that debt (with its interest coverage ratio ).

China Molybdenum has a low net debt to EBITDA ratio of just 0.64. And its EBIT covers its interest charges 20.9 times. So we’re pretty relaxed about his super-conservative use of debt. On top of that, we are happy to report that China Molybdenum increased its EBIT by 38%, reducing the specter of future debt repayments. The balance sheet is clearly the area to focus on when analyzing debt. But ultimately, the company’s future profitability will decide whether China Molybdenum can strengthen its balance sheet over time. So if you are focused on the future, you can check out this free report showing analyst earnings forecast.

Finally, a business needs free cash flow to pay off its debts; book profits are not enough. We must therefore clearly examine whether this EBIT generates a corresponding free cash flow. Over the past two years, China Molybdenum has had negative free cash flow, overall. Debt is generally more expensive and almost always riskier in the hands of a company with negative free cash flow. Shareholders should hope for an improvement.

Our point of view

China Molybdenum’s ability to cover its interest charges with its EBIT and its EBIT growth rate have reinforced our ability to manage its debt. But truth be told, his conversion from EBIT to free cash flow had us biting our nails. Looking at all this data, we feel a bit cautious about China Molybdenum’s debt levels. While we understand that debt can improve return on equity, we suggest shareholders keep a close eye on their level of debt, lest it increase. There is no doubt that we learn the most about debt from the balance sheet. However, not all investment risks reside on the balance sheet, far from it. These risks can be difficult to spot. Every business has them, and we’ve spotted 1 warning sign for Molybdenum from China you should know.

In the end, it’s often best to focus on companies that aren’t in debt. You can access our special list of these companies (all with a track record of earnings growth). It’s free.

This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.

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