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 China Northern Rare Earth (Group) High-Tech Co.,Ltd (SHSE:600111) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is China Northern Rare Earth (Group) High-TechLtd's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2024 China Northern Rare Earth (Group) High-TechLtd had CN¥8.24b of debt, an increase on CN¥7.40b, over one year. However, it also had CN¥6.58b in cash, and so its net debt is CN¥1.66b.

A Look At China Northern Rare Earth (Group) High-TechLtd's Liabilities

Zooming in on the latest balance sheet data, we can see that China Northern Rare Earth (Group) High-TechLtd had liabilities of CN¥9.27b due within 12 months and liabilities of CN¥5.28b due beyond that. Offsetting this, it had CN¥6.58b in cash and CN¥8.45b in receivables that were due within 12 months. So it can boast CN¥472.2m more liquid assets than total liabilities.

This state of affairs indicates that China Northern Rare Earth (Group) High-TechLtd's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So it's very unlikely that the CN¥85.4b company is short on cash, but still worth keeping an eye on the balance sheet.

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). 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).

China Northern Rare Earth (Group) High-TechLtd's net debt is only 0.58 times its EBITDA. And its EBIT easily covers its interest expense, being 12.6 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. The modesty of its debt load may become crucial for China Northern Rare Earth (Group) High-TechLtd if management cannot prevent a repeat of the 28% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if China Northern Rare Earth (Group) High-TechLtd can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

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. Looking at the most recent three years, China Northern Rare Earth (Group) High-TechLtd recorded free cash flow of 47% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

China Northern Rare Earth (Group) High-TechLtd's EBIT growth rate was a real negative on this analysis, although the other factors we considered were considerably better. There's no doubt that its ability to to cover its interest expense with its EBIT is pretty flash. Considering this range of data points, we think China Northern Rare Earth (Group) High-TechLtd is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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. To that end, you should be aware of the 1 warning sign we've spotted with China Northern Rare Earth (Group) High-TechLtd .

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.