IRICO Group New Energy (HKG:438) Seems To Use Debt Quite Sensibly

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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies IRICO Group New Energy Company Limited (HKG:438) makes use of debt. But is this debt a concern to shareholders?

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. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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 IRICO Group New Energy

How Much Debt Does IRICO Group New Energy Carry?

The image below, which you can click on for greater detail, shows that IRICO Group New Energy had debt of CN¥962.8m at the end of December 2020, a reduction from CN¥1.19b over a year. However, it does have CN¥771.7m in cash offsetting this, leading to net debt of about CN¥191.2m.

How Healthy Is IRICO Group New Energy's Balance Sheet?

The latest balance sheet data shows that IRICO Group New Energy had liabilities of CN¥2.82b due within a year, and liabilities of CN¥415.8m falling due after that. On the other hand, it had cash of CN¥771.7m and CN¥977.7m worth of receivables due within a year. So it has liabilities totalling CN¥1.49b more than its cash and near-term receivables, combined.

IRICO Group New Energy has a market capitalization of CN¥3.16b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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

Looking at its net debt to EBITDA of 0.46 and interest cover of 4.7 times, it seems to us that IRICO Group New Energy is probably using debt in a pretty reasonable way. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Importantly, IRICO Group New Energy grew its EBIT by 40% over the last twelve months, and that growth will make it easier to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine IRICO Group New Energy'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 we always check how much of that EBIT is translated into free cash flow. Considering the last three years, IRICO Group New Energy actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Our View

Both IRICO Group New Energy's ability to to grow its EBIT and its net debt to EBITDA gave us comfort that it can handle its debt. But truth be told its conversion of EBIT to free cash flow had us nibbling our nails. Looking at all this data makes us feel a little cautious about IRICO Group New Energy's debt levels. 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. 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 IRICO Group New Energy is showing 3 warning signs in our investment analysis , and 2 of those shouldn't be ignored...

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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