We Think Hainan Drinda New Energy Technology (SZSE:002865) Is Taking Some Risk With Its Debt

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.' 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. We note that Hainan Drinda New Energy Technology Co., Ltd. (SZSE:002865) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Hainan Drinda New Energy Technology

What Is Hainan Drinda New Energy Technology's Net Debt?

The image below, which you can click on for greater detail, shows that Hainan Drinda New Energy Technology had debt of CN¥3.02b at the end of March 2024, a reduction from CN¥3.27b over a year. On the flip side, it has CN¥2.50b in cash leading to net debt of about CN¥516.8m.

How Strong Is Hainan Drinda New Energy Technology's Balance Sheet?

According to the last reported balance sheet, Hainan Drinda New Energy Technology had liabilities of CN¥4.90b due within 12 months, and liabilities of CN¥7.35b due beyond 12 months. On the other hand, it had cash of CN¥2.50b and CN¥1.31b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥8.44b.

Given this deficit is actually higher than the company's market capitalization of CN¥7.93b, we think shareholders really should watch Hainan Drinda New Energy Technology's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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). 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).

With net debt sitting at just 0.25 times EBITDA, Hainan Drinda New Energy Technology is arguably pretty conservatively geared. And this view is supported by the solid interest coverage, with EBIT coming in at 7.3 times the interest expense over the last year. Also positive, Hainan Drinda New Energy Technology grew its EBIT by 22% in the last year, and that should make it easier to pay down debt, going forward. 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 Hainan Drinda New Energy Technology 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Hainan Drinda New Energy Technology saw substantial negative free cash flow, in total. 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

Hainan Drinda New Energy Technology's struggle to convert EBIT to free cash flow had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. In particular, its net debt to EBITDA was re-invigorating. When we consider all the factors discussed, it seems to us that Hainan Drinda New Energy Technology is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. To that end, you should learn about the 5 warning signs we've spotted with Hainan Drinda New Energy Technology (including 1 which is significant) .

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.