Does Chongqing Iron & Steel (HKG: 1053) have a healthy track record?
Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett said “volatility is far from risk.” It is only natural to consider a company’s balance sheet when considering how risky it is, as debt is often involved when a business collapses. We can see that Chongqing Iron & Steel Company Limited (HKG: 1053) uses debt in his business. But the most important question is: what risk does this debt create?
Why Does Debt Bring Risk?
Debt helps a business until the business struggles to repay it, either with new capital or with free cash flow. In the worst case scenario, a business can go bankrupt if it cannot pay its creditors. However, a more common (but still costly) event is when a company has to issue stock at bargain prices, constantly diluting shareholders, just to strengthen its balance sheet. By replacing dilution, however, debt can be a very good tool for companies that need capital to invest in growth at high rates of return. When we look at debt levels, we first look at cash and debt levels, together.
Check out our latest review for Chongqing Iron & Steel
What is Chongqing Iron & Steel’s net debt?
The image below, which you can click for more details, shows that in September 2021, Chongqing Iron & Steel had a debt of CN 5.99 billion, compared to CN 5.45 billion in a year. On the other hand, he has CN Â¥ 4.98b in cash, resulting in net debt of around CN Â¥ 1.01b.
A look at the responsibilities of Chongqing Iron & Steel
According to the latest published balance sheet, Chongqing Iron & Steel had liabilities of CN Â¥ 13.5b due within 12 months and liabilities of CN Â¥ 5.14b due beyond 12 months. In compensation for these obligations, it had cash of CNN 4.98 billion as well as receivables valued at CN 1.85 billion due within 12 months. Thus, its liabilities exceed the sum of its cash and (short-term) receivables by CN Â¥ 11.8b.
This deficit is substantial compared to its market capitalization of CN 17.7 billion, so he suggests shareholders keep an eye on Chongqing Iron & Steel’s use of debt. If its lenders asked it to consolidate the balance sheet, shareholders would likely face severe dilution.
We measure a company’s indebtedness relative to its earning capacity by looking at its net debt divided by its earnings before interest, taxes, depreciation, and amortization (EBITDA) and calculating the ease with which its earnings before interest and taxes (EBIT ) covers its interests. costs (interest coverage). Thus, we look at debt versus earnings with and without amortization expenses.
Chongqing Iron & Steel’s net debt is only 0.22 times its EBITDA. And its EBIT covers its interest costs a whopping 10.4 times. So we’re pretty relaxed about its ultra-conservative use of debt. Even more impressive was the fact that Chongqing Iron & Steel increased its EBIT by 573% year over year. This boost will make it even easier to pay down debt in the future. There is no doubt that we learn the most about debt from the balance sheet. But it is the profits of Chongqing Iron & Steel that will influence the balance sheet in the future. So, when considering debt, it is really worth looking at the profit trend. Click here for an interactive snapshot.
Finally, while the IRS may love accounting profits, lenders only accept hard cash. It is therefore worth checking to what extent this EBIT is supported by free cash flow. Over the past three years, Chongqing Iron & Steel has reported free cash flow of 2.9% of its EBIT, which is really quite low. This low level of cash conversion undermines its ability to manage and repay its debts.
Our point of view
Chongqing Iron & Steel’s ability to increase its EBIT and net debt relative to EBITDA has bolstered us in its ability to manage its debt. In contrast, our confidence was shaken by his apparent struggle to convert EBIT into free cash flow. When we consider all the elements mentioned above, it seems to us that Chongqing Iron & Steel is managing its debt quite well. But beware: we believe debt levels are high enough to warrant continued monitoring. The balance sheet is clearly the area to focus on when analyzing debt. But at the end of the day, every business can contain risks that exist off the balance sheet. We have identified 1 warning sign with Chongqing Iron & Steel, and understanding them should be part of your investment process.
Of course, if you are the type of investor who prefers to buy stocks without going into debt, feel free to check out our exclusive list of cash net growth stocks today.
Do you have any feedback on this item? Are you worried about the content? Get in touch with us directly. You can also send an email to the editorial team (at) simplywallst.com.
This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only 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 into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in any of the stocks mentioned.