The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital. It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Ruifeng Power Group Company Limited (HKG:2025) does carry debt. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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.
What Is Ruifeng Power Group's Debt?
The chart below, which you can click on for greater detail, shows that Ruifeng Power Group had CN¥217.0m in debt in June 2019; about the same as the year before. However, it does have CN¥190.8m in cash offsetting this, leading to net debt of about CN¥26.2m.
How Healthy Is Ruifeng Power Group's Balance Sheet?
We can see from the most recent balance sheet that Ruifeng Power Group had liabilities of CN¥422.2m falling due within a year, and liabilities of CN¥60.0m due beyond that. On the other hand, it had cash of CN¥190.8m and CN¥255.9m worth of receivables due within a year. So its liabilities total CN¥35.6m more than the combination of its cash and short-term receivables.
Of course, Ruifeng Power Group has a market capitalization of CN¥1.16b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
Ruifeng Power Group has a low net debt to EBITDA ratio of only 0.16. And its EBIT covers its interest expense a whopping 11.0 times over. So we're pretty relaxed about its super-conservative use of debt. In fact Ruifeng Power Group's saving grace is its low debt levels, because its EBIT has tanked 26% in the last twelve months. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. There's no doubt that we learn most about debt from the balance sheet. But it is Ruifeng Power Group's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Ruifeng Power Group recorded negative free cash flow, in total. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for and improvement.
Both Ruifeng Power Group's EBIT growth rate and its conversion of EBIT to free cash flow were discouraging. But at least its net debt to EBITDA is a gleaming silver lining to those clouds. Looking at all the angles mentioned above, it does seem to us that Ruifeng Power Group is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of Ruifeng Power Group's earnings per share history for free.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.