Is Rare Earth Magnesium Technology Group Holdings (HKG:601) A Risky Investment?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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. As with many other companies Rare Earth Magnesium Technology Group Holdings Limited (HKG:601) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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, 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 Rare Earth Magnesium Technology Group Holdings

What Is Rare Earth Magnesium Technology Group Holdings's Net Debt?

As you can see below, Rare Earth Magnesium Technology Group Holdings had HK$872.3m of debt at December 2020, down from HK$985.5m a year prior. However, it does have HK$36.1m in cash offsetting this, leading to net debt of about HK$836.2m.

How Healthy Is Rare Earth Magnesium Technology Group Holdings' Balance Sheet?

The latest balance sheet data shows that Rare Earth Magnesium Technology Group Holdings had liabilities of HK$953.7m due within a year, and liabilities of HK$151.2m falling due after that. Offsetting these obligations, it had cash of HK$36.1m as well as receivables valued at HK$182.7m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$886.1m.

This deficit casts a shadow over the HK$553.1m company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Rare Earth Magnesium Technology Group Holdings would likely require a major re-capitalisation if it had to pay its creditors today.

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).

Rare Earth Magnesium Technology Group Holdings shareholders face the double whammy of a high net debt to EBITDA ratio (6.8), and fairly weak interest coverage, since EBIT is just 0.22 times the interest expense. This means we'd consider it to have a heavy debt load. Worse, Rare Earth Magnesium Technology Group Holdings's EBIT was down 93% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Rare Earth Magnesium Technology Group Holdings 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 always check how much of that EBIT is translated into free cash flow. In the last three years, Rare Earth Magnesium Technology Group Holdings's free cash flow amounted to 32% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

To be frank both Rare Earth Magnesium Technology Group Holdings's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. And furthermore, its net debt to EBITDA also fails to instill confidence. Considering all the factors previously mentioned, we think that Rare Earth Magnesium Technology Group Holdings really is carrying too much debt. To us, that makes the stock rather risky, like walking through a dog park with your eyes closed. But some investors may feel differently. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 5 warning signs with Rare Earth Magnesium Technology Group Holdings (at least 2 which are potentially serious) , and understanding them should be part of your investment process.

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. 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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