Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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 can see that Zhengzhou Coal Mining Machinery Group Company Limited (SHSE:601717) does use debt in its business. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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. The first step when considering a company's debt levels is to consider its cash and debt together.
See our latest analysis for Zhengzhou Coal Mining Machinery Group
What Is Zhengzhou Coal Mining Machinery Group's Net Debt?
The image below, which you can click on for greater detail, shows that at June 2023 Zhengzhou Coal Mining Machinery Group had debt of CN¥8.74b, up from CN¥6.88b in one year. However, it does have CN¥12.5b in cash offsetting this, leading to net cash of CN¥3.78b.
How Strong Is Zhengzhou Coal Mining Machinery Group's Balance Sheet?
According to the last reported balance sheet, Zhengzhou Coal Mining Machinery Group had liabilities of CN¥18.4b due within 12 months, and liabilities of CN¥9.71b due beyond 12 months. Offsetting this, it had CN¥12.5b in cash and CN¥12.7b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥2.85b.
Since publicly traded Zhengzhou Coal Mining Machinery Group shares are worth a total of CN¥20.5b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. While it does have liabilities worth noting, Zhengzhou Coal Mining Machinery Group also has more cash than debt, so we're pretty confident it can manage its debt safely.
Another good sign is that Zhengzhou Coal Mining Machinery Group has been able to increase its EBIT by 28% in twelve months, making it easier to pay down debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Zhengzhou Coal Mining Machinery Group'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, a company can only pay off debt with cold hard cash, not accounting profits. While Zhengzhou Coal Mining Machinery Group has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. During the last three years, Zhengzhou Coal Mining Machinery Group produced sturdy free cash flow equating to 68% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Although Zhengzhou Coal Mining Machinery Group's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of CN¥3.78b. And we liked the look of last year's 28% year-on-year EBIT growth. So is Zhengzhou Coal Mining Machinery Group's debt a risk? It doesn't seem so to us. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. To that end, you should be aware of the 1 warning sign we've spotted with Zhengzhou Coal Mining Machinery Group .
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.