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 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. We can see that China Ludao Technology Company Limited (HKG:2023) does use debt in its business. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
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. 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 think about a company’s use of debt, we first look at cash and debt together.
How Much Debt Does China Ludao Technology Carry?
You can click the graphic below for the historical numbers, but it shows that as of December 2018 China Ludao Technology had CN¥259.0m of debt, an increase on CN¥141.3m, over one year. On the flip side, it has CN¥178.8m in cash leading to net debt of about CN¥80.1m.
A Look At China Ludao Technology’s Liabilities
Zooming in on the latest balance sheet data, we can see that China Ludao Technology had liabilities of CN¥257.6m due within 12 months and liabilities of CN¥150.7m due beyond that. On the other hand, it had cash of CN¥178.8m and CN¥143.7m worth of receivables due within a year. So it has liabilities totalling CN¥85.8m more than its cash and near-term receivables, combined.
Since publicly traded China Ludao Technology shares are worth a total of CN¥486.6m, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.
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.
Even though China Ludao Technology’s debt is only 1.8, its interest cover is really very low at 2.2. This does have us wondering if the company pays high interest because it is considered risky. In any case, it’s safe to say the company has meaningful debt. One way China Ludao Technology could vanquish its debt would be if it stops borrowing more but conitinues to grow EBIT at around 16%, as it did over the last year. When analysing debt levels, the balance sheet is the obvious place to start. But it is China Ludao Technology’s earnings that will influence how the balance sheet holds up in the future. 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. During the last three years, China Ludao Technology burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
China Ludao Technology’s conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. For example, its EBIT growth rate is relatively strong. When we consider all the factors discussed, it seems to us that China Ludao Technology is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. In light of our reservations about the company’s balance sheet, it seems sensible to check if insiders have been selling shares recently.
If, after all that, you’re more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at email@example.com. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.