Red Avenue New Materials Group (SHSE:603650) Has A Pretty Healthy Balance Sheet

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Red Avenue New Materials Group Co., Ltd. (SHSE:603650) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Red Avenue New Materials Group

How Much Debt Does Red Avenue New Materials Group Carry?

The image below, which you can click on for greater detail, shows that at June 2024 Red Avenue New Materials Group had debt of CN¥3.38b, up from CN¥2.75b in one year. On the flip side, it has CN¥1.04b in cash leading to net debt of about CN¥2.34b.

A Look At Red Avenue New Materials Group's Liabilities

According to the last reported balance sheet, Red Avenue New Materials Group had liabilities of CN¥1.94b due within 12 months, and liabilities of CN¥2.58b due beyond 12 months. Offsetting this, it had CN¥1.04b in cash and CN¥1.21b in receivables that were due within 12 months. So it has liabilities totalling CN¥2.27b more than its cash and near-term receivables, combined.

Of course, Red Avenue New Materials Group has a market capitalization of CN¥15.8b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Strangely Red Avenue New Materials Group has a sky high EBITDA ratio of 5.5, implying high debt, but a strong interest coverage of 1k. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. Importantly, Red Avenue New Materials Group grew its EBIT by 39% over the last twelve months, and that growth will make it easier to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Red Avenue New Materials Group 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. During the last three years, Red Avenue New Materials Group burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

Red Avenue New Materials Group's conversion of EBIT to free cash flow was a real negative on this analysis, as was its net debt to EBITDA. But like a ballerina ending on a perfect pirouette, it has not trouble covering its interest expense with its EBIT. When we consider all the factors mentioned above, we do feel a bit cautious about Red Avenue New Materials Group's use of debt. 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. For instance, we've identified 2 warning signs for Red Avenue New Materials Group that you should be aware of.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.