These 4 Measures Indicate That Red Avenue New Materials Group (SHSE:603650) Is Using Debt Reasonably Well

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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. Importantly, Red Avenue New Materials Group Co., Ltd. (SHSE:603650) does carry debt. But the more important question is: how much risk is that debt creating?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Red Avenue New Materials Group

What Is Red Avenue New Materials Group's Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 Red Avenue New Materials Group had CN¥2.94b of debt, an increase on CN¥2.67b, over one year. However, it does have CN¥857.3m in cash offsetting this, leading to net debt of about CN¥2.09b.

How Healthy Is Red Avenue New Materials Group's Balance Sheet?

We can see from the most recent balance sheet that Red Avenue New Materials Group had liabilities of CN¥1.77b falling due within a year, and liabilities of CN¥2.27b due beyond that. Offsetting this, it had CN¥857.3m in cash and CN¥1.18b in receivables that were due within 12 months. So it has liabilities totalling CN¥2.00b more than its cash and near-term receivables, combined.

Given Red Avenue New Materials Group has a market capitalization of CN¥19.2b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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).

As it happens Red Avenue New Materials Group has a fairly concerning net debt to EBITDA ratio of 5.4 but very strong interest coverage of 1k. So either it has access to very cheap long term debt or that interest expense is going to grow! We note that Red Avenue New Materials Group grew its EBIT by 27% in the last year, and that should make it easier to pay down debt, going forward. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Red Avenue New Materials Group's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Red Avenue New Materials Group burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

We weren't impressed with Red Avenue New Materials Group's net debt to EBITDA, and its conversion of EBIT to free cash flow made us cautious. 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. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example Red Avenue New Materials Group has 2 warning signs (and 1 which is potentially serious) we think you should know about.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.