Here's Why Add New Energy Investment Holdings Group (HKG:2623) Has A Meaningful Debt Burden

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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Add New Energy Investment Holdings Group Limited (HKG:2623) does use debt in its business. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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.

View our latest analysis for Add New Energy Investment Holdings Group

How Much Debt Does Add New Energy Investment Holdings Group Carry?

The image below, which you can click on for greater detail, shows that at June 2021 Add New Energy Investment Holdings Group had debt of CN¥186.7m, up from CN¥167.9m in one year. However, it does have CN¥140.4m in cash offsetting this, leading to net debt of about CN¥46.2m.

A Look At Add New Energy Investment Holdings Group's Liabilities

Zooming in on the latest balance sheet data, we can see that Add New Energy Investment Holdings Group had liabilities of CN¥335.3m due within 12 months and liabilities of CN¥73.5m due beyond that. Offsetting this, it had CN¥140.4m in cash and CN¥30.9m in receivables that were due within 12 months. So its liabilities total CN¥237.6m more than the combination of its cash and short-term receivables.

Add New Energy Investment Holdings Group has a market capitalization of CN¥685.7m, so it could very likely raise cash to ameliorate 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.

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). 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).

Given net debt is only 1.0 times EBITDA, it is initially surprising to see that Add New Energy Investment Holdings Group's EBIT has low interest coverage of 1.8 times. So while we're not necessarily alarmed we think that its debt is far from trivial. We also note that Add New Energy Investment Holdings Group improved its EBIT from a last year's loss to a positive CN¥31m. When analysing debt levels, the balance sheet is the obvious place to start. But it is Add New Energy Investment Holdings Group's earnings that will influence how the balance sheet holds up in the future. 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Add New Energy Investment Holdings Group 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

To be frank both Add New Energy Investment Holdings Group's interest cover and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But at least it's pretty decent at managing its debt, based on its EBITDA,; that's encouraging. Once we consider all the factors above, together, it seems to us that Add New Energy Investment Holdings Group's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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 instance, we've identified 3 warning signs for Add New Energy Investment Holdings Group (1 is concerning) 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.

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.

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