Here's Why China Northern Rare Earth (Group) High-TechLtd (SHSE:600111) Can Manage Its Debt Responsibly

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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, China Northern Rare Earth (Group) High-Tech Co.,Ltd (SHSE:600111) does carry debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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 step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for China Northern Rare Earth (Group) High-TechLtd

What Is China Northern Rare Earth (Group) High-TechLtd's Net Debt?

As you can see below, at the end of March 2024, China Northern Rare Earth (Group) High-TechLtd had CN¥7.86b of debt, up from CN¥6.38b a year ago. Click the image for more detail. On the flip side, it has CN¥6.03b in cash leading to net debt of about CN¥1.82b.

A Look At China Northern Rare Earth (Group) High-TechLtd's Liabilities

According to the last reported balance sheet, China Northern Rare Earth (Group) High-TechLtd had liabilities of CN¥10.1b due within 12 months, and liabilities of CN¥4.72b due beyond 12 months. Offsetting these obligations, it had cash of CN¥6.03b as well as receivables valued at CN¥8.56b due within 12 months. So these liquid assets roughly match the total liabilities.

Having regard to China Northern Rare Earth (Group) High-TechLtd's size, it seems that its liquid assets are well balanced with its total liabilities. So it's very unlikely that the CN¥65.8b company is short on cash, but still worth keeping an eye on the balance sheet.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

China Northern Rare Earth (Group) High-TechLtd has a low net debt to EBITDA ratio of only 0.66. And its EBIT easily covers its interest expense, being 15.8 times the size. So we're pretty relaxed about its super-conservative use of debt. It is just as well that China Northern Rare Earth (Group) High-TechLtd's load is not too heavy, because its EBIT was down 67% over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if China Northern Rare Earth (Group) High-TechLtd can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, China Northern Rare Earth (Group) High-TechLtd's free cash flow amounted to 44% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

Based on what we've seen China Northern Rare Earth (Group) High-TechLtd is not finding it easy, given its EBIT growth rate, but the other factors we considered give us cause to be optimistic. There's no doubt that its ability to to cover its interest expense with its EBIT is pretty flash. Looking at all this data makes us feel a little cautious about China Northern Rare Earth (Group) High-TechLtd's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for China Northern Rare Earth (Group) High-TechLtd you should know about.

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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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.