Does Ruifeng Power Group (HKG:2025) Have A Healthy Balance Sheet?

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 can see that Ruifeng Power Group Company Limited (HKG:2025) does use debt in its business. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Ruifeng Power Group

What Is Ruifeng Power Group's Net Debt?

The image below, which you can click on for greater detail, shows that at December 2020 Ruifeng Power Group had debt of CN¥160.0m, up from CN¥120.9m in one year. However, it also had CN¥26.3m in cash, and so its net debt is CN¥133.7m.

How Strong Is Ruifeng Power Group's Balance Sheet?

The latest balance sheet data shows that Ruifeng Power Group had liabilities of CN¥427.7m due within a year, and liabilities of CN¥54.7m falling due after that. On the other hand, it had cash of CN¥26.3m and CN¥282.7m worth of receivables due within a year. So its liabilities total CN¥173.4m more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Ruifeng Power Group is worth CN¥671.4m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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

With net debt sitting at just 1.2 times EBITDA, Ruifeng Power Group is arguably pretty conservatively geared. And it boasts interest cover of 7.8 times, which is more than adequate. Fortunately, Ruifeng Power Group grew its EBIT by 7.0% in the last year, making that debt load look even more manageable. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Ruifeng Power Group will need earnings to service that debt. 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Considering the last three years, Ruifeng Power Group actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

Ruifeng Power Group'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. For example, its interest cover is relatively strong. We think that Ruifeng Power Group's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. Be aware that Ruifeng Power Group is showing 1 warning sign in our investment analysis , 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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