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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.' 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 note that Rare Earth Magnesium Technology Group Holdings Limited (HKG:601) does have debt on its balance sheet. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.
Check out our latest analysis for Rare Earth Magnesium Technology Group Holdings
What Is Rare Earth Magnesium Technology Group Holdings's Debt?
You can click the graphic below for the historical numbers, but it shows that Rare Earth Magnesium Technology Group Holdings had HK$910.1m of debt in December 2018, down from HK$1.12b, one year before. On the flip side, it has HK$131.5m in cash leading to net debt of about HK$778.6m.
How Healthy Is Rare Earth Magnesium Technology Group Holdings's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Rare Earth Magnesium Technology Group Holdings had liabilities of HK$172.1m due within 12 months and liabilities of HK$928.9m due beyond that. Offsetting this, it had HK$131.5m in cash and HK$282.2m in receivables that were due within 12 months. So it has liabilities totalling HK$687.3m more than its cash and near-term receivables, combined.
This deficit isn't so bad because Rare Earth Magnesium Technology Group Holdings is worth HK$1.81b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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).