David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 Zhejiang Huayou Cobalt Co., Ltd (SHSE:603799) makes use of debt. 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. If things get really bad, the lenders can take control of the business. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Zhejiang Huayou Cobalt Carry?
The image below, which you can click on for greater detail, shows that at March 2024 Zhejiang Huayou Cobalt had debt of CN¥60.2b, up from CN¥48.3b in one year. However, it also had CN¥17.7b in cash, and so its net debt is CN¥42.5b.
A Look At Zhejiang Huayou Cobalt's Liabilities
Zooming in on the latest balance sheet data, we can see that Zhejiang Huayou Cobalt had liabilities of CN¥51.5b due within 12 months and liabilities of CN¥31.9b due beyond that. Offsetting these obligations, it had cash of CN¥17.7b as well as receivables valued at CN¥10.1b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥55.6b.
Given this deficit is actually higher than the company's market capitalization of CN¥51.1b, we think shareholders really should watch Zhejiang Huayou Cobalt's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Zhejiang Huayou Cobalt has a rather high debt to EBITDA ratio of 5.6 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 3.8 times, suggesting it can responsibly service its obligations. Even worse, Zhejiang Huayou Cobalt saw its EBIT tank 36% over the last 12 months. 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 Zhejiang Huayou Cobalt's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
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, Zhejiang Huayou Cobalt saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.
Our View
On the face of it, Zhejiang Huayou Cobalt's conversion of EBIT to free cash flow left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. And even its level of total liabilities fails to inspire much confidence. Taking into account all the aforementioned factors, it looks like Zhejiang Huayou Cobalt has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. 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. We've identified 3 warning signs with Zhejiang Huayou Cobalt (at least 1 which makes us a bit uncomfortable) , and understanding them should be part of your investment process.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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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.