Is CGN Mining (HKG:1164) using too much debt?
David Iben said it well when he said: “Volatility is not a risk that interests us. What matters to us is to avoid the 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, CGN Mining Company Limited (HKG:1164) is in debt. But the real question is whether this debt makes the business risky.
When is debt dangerous?
Debt and other liabilities become risky for a business when it cannot easily meet those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company cannot meet its legal debt repayment obligations, shareholders could walk away with nothing. However, a more common (but still costly) event is when a company has to issue stock at bargain prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, many companies use debt to finance their growth, without any negative consequences. When we think about a company’s use of debt, we first look at cash and debt together.
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What is CGN Mining’s net debt?
You can click on the graph below for historical figures, but it shows that in June 2022, CGN Mining had HK$2.27 billion in debt, an increase from HK$1.31 billion, over a year. However, since it has a cash reserve of HK$1.27 billion, its net debt is lower at around HK$995.0 million.
How strong is CGN Mining’s balance sheet?
We can see from the most recent balance sheet that CGN Mining had liabilities of HK$3.38 billion due in one year, and liabilities of HK$442.9 million due beyond. In return, he had HK$1.27 billion in cash and HK$441.8 million in debt due within 12 months. Thus, its liabilities total HK$2.11 billion more than the combination of its cash and short-term receivables.
This shortfall is not that bad as CGN Mining is worth HK$5.55 billion and therefore could probably raise enough capital to shore up its balance sheet, should the need arise. But it is clear that it is essential to examine closely whether it can manage its debt without dilution.
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 ).
With a net debt to EBITDA ratio of 5.6, it’s fair to say that CGN Mining has significant debt. However, its interest coverage of 3.3 is reasonably strong, which is a good sign. On the bright side, CGN Mining has increased its EBIT by 53% over the past year. Like a mother’s loving embrace of a newborn, this kind of growth builds resilience, putting the company in a stronger position to manage its debt. When analyzing debt levels, the balance sheet is the obvious starting point. But it is future earnings, more than anything, that will determine CGN Mining’s ability to maintain a healthy balance sheet in the future. So if you are focused on the future, you can check out this free report showing analyst earnings forecast.
Finally, a company can only repay its debts with cold hard cash, not with book profits. We therefore always check how much of this EBIT is converted into free cash flow. Over the past three years, CGN Mining has experienced substantial negative free cash flow, in total. While this may be the result of spending for growth, it makes debt much riskier.
Our point of view
Neither CGN Mining’s ability to convert EBIT to free cash flow nor its net debt to EBITDA gave us confidence in its ability to take on more debt. But its EBIT growth rate tells a very different story and suggests some resilience. Considering the above factors, we believe that CGN Mining’s debt poses certain risks to the business. So even if this leverage increases return on equity, we wouldn’t really want to see it increase from now on. 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 outside of the balance sheet. For example, we have identified 2 warning signs for CGN Mining of which you should be aware.
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.
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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.