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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Jiangsu Ruitai New Energy Materials Co., Ltd. (SZSE:301238) makes use of debt. But the more important question is: how much risk is that debt creating?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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 step when considering a company's debt levels is to consider its cash and debt together.
What Is Jiangsu Ruitai New Energy Materials's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of September 2023 Jiangsu Ruitai New Energy Materials had CN¥1.25b of debt, an increase on CN¥262.9m, over one year. However, it does have CN¥6.05b in cash offsetting this, leading to net cash of CN¥4.80b.
How Strong Is Jiangsu Ruitai New Energy Materials' Balance Sheet?
According to the last reported balance sheet, Jiangsu Ruitai New Energy Materials had liabilities of CN¥2.63b due within 12 months, and liabilities of CN¥720.7m due beyond 12 months. Offsetting this, it had CN¥6.05b in cash and CN¥2.40b in receivables that were due within 12 months. So it actually has CN¥5.10b more liquid assets than total liabilities.
This surplus strongly suggests that Jiangsu Ruitai New Energy Materials has a rock-solid balance sheet (and the debt is of no concern whatsoever). On this view, lenders should feel as safe as the beloved of a black-belt karate master. Simply put, the fact that Jiangsu Ruitai New Energy Materials has more cash than debt is arguably a good indication that it can manage its debt safely.
In fact Jiangsu Ruitai New Energy Materials's saving grace is its low debt levels, because its EBIT has tanked 51% in the last twelve months. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Jiangsu Ruitai New Energy Materials will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. While Jiangsu Ruitai New Energy Materials has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last three years, Jiangsu Ruitai New Energy Materials reported free cash flow worth 18% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.
Summing Up
While we empathize with investors who find debt concerning, you should keep in mind that Jiangsu Ruitai New Energy Materials has net cash of CN¥4.80b, as well as more liquid assets than liabilities. So we are not troubled with Jiangsu Ruitai New Energy Materials's debt use. 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 1 warning sign with Jiangsu Ruitai New Energy Materials , 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. 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.