Berkshire Hathaway’s Charlie Munger-backed external fund manager Li Lu is quick to say “The biggest risk in investing is not price volatility, but whether you will suffer a permanent loss of capital”. When we think about how risky a business is, we always like to look at its use of debt because debt overload can lead to bankruptcy. Like many other companies Jiangxi Copper Company Limited (HKG: 358) uses the debt. But should shareholders be concerned about its use of debt?
Why Does Debt Bring Risk?
Generally speaking, debt only becomes a real problem when a company cannot repay it easily, either by raising capital or with its own 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) situation is where a company has to dilute its shareholders at a cheap share price just to get its debt under control. Of course, many companies use debt to finance their growth without negative consequences. When we look at debt levels, we first consider both liquidity and debt levels.
What is Jiangxi Copper’s net debt?
The graph below, which you can click for more details, shows that Jiangxi Copper had 55.4 billion yuan in debt as of March 2021; about the same as the year before. However, it has CNN 33.5 billion in cash offsetting this, which leads to net debt of around CNN 21.9 billion.
How strong is Jiangxi Copper’s balance sheet?
We can see from the most recent balance sheet that Jiangxi Copper had debts of CN ¥ 64.1b due within one year, and debts of CN ¥ 20.7b due beyond. On the other hand, he had CN 33.5 billion in cash and CN 12.4 billion in receivables due within one year. It therefore has liabilities totaling CN 38.8 billion more than its combined cash and short-term receivables.
While this may sound like a lot, it’s not that big of a deal since Jiangxi Copper has a massive market cap of 78.8 billion yen, and could therefore likely strengthen its balance sheet by raising capital if needed. However, it is always worth taking a close look at your ability to repay your debt.
We measure a company’s debt load relative to its earning capacity by looking at its net debt divided by its earnings before interest, taxes, depreciation, and amortization (EBITDA) and calculating how easily its earnings before interest and taxes (EBIT) covers its interest costs (interest coverage). The advantage of this approach is that we take into account both the absolute amount of debt (with net debt versus EBITDA) and the actual interest charges associated with this debt (with its coverage rate). interests).
Jiangxi Copper’s net debt stands at a very reasonable level of 1.9 times its EBITDA, while its EBIT only covered its interest expense 3.7 times last year. While these numbers don’t worry us, it’s worth noting that the cost of the company’s debt does have a real impact. Fortunately, Jiangxi Copper is increasing its EBIT faster than former Australian Prime Minister Bob Hawke, posting a 121% gain in the past twelve months. When analyzing debt levels, the balance sheet is the obvious starting point. But ultimately, the company’s future profitability will decide whether Jiangxi Copper can strengthen its balance sheet over time. So if you are focused on the future you can check this out free report showing analysts’ earnings forecasts.
Finally, while the IRS may love accounting profits, lenders only accept hard cash. We must therefore clearly check whether this EBIT generates a corresponding free cash flow. Over the past three years, Jiangxi Copper’s free cash flow has been 37% of its EBIT, less than we expected. This low cash conversion makes debt management more difficult.
Our point of view
Based on our analysis, Jiangxi Copper’s EBIT growth rate should indicate that it will not have too many problems with its debt. However, our other observations were not so encouraging. For example, it looks like he has to struggle a bit to cover his interest costs with his EBIT. Looking at all of this data, we feel a little cautious about Jiangxi Copper’s debt levels. While debt has its advantage in terms of potential higher returns, we believe shareholders should definitely consider how leverage levels might make the stock riskier. There is no doubt that we learn the most about debt from the balance sheet. But at the end of the day, every business can contain risks that exist off the balance sheet. For example, we have identified 3 warning signs for Jiangxi Copper (1 is of concern) you must be aware.
If you are interested in investing in companies that can generate profits without the burden of debt, check out this page free list of growing companies that have net cash on the balance sheet.
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