Warren Buffett famously said, ‘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 Virscend Education Company Limited (HKG:1565) 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 assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Virscend Education’s Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 Virscend Education had CN¥1.22b of debt, an increase on CN¥873, over one year. However, it also had CN¥541.8m in cash, and so its net debt is CN¥677.7m.
How Healthy Is Virscend Education’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Virscend Education had liabilities of CN¥1.48b due within 12 months and liabilities of CN¥1.09b due beyond that. Offsetting these obligations, it had cash of CN¥541.8m as well as receivables valued at CN¥290.4m due within 12 months. So it has liabilities totalling CN¥1.75b more than its cash and near-term receivables, combined.
This deficit isn’t so bad because Virscend Education is worth CN¥5.43b, 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 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
With net debt sitting at just 1.2 times EBITDA, Virscend Education is arguably pretty conservatively geared. And this view is supported by the solid interest coverage, with EBIT coming in at 8.5 times the interest expense over the last year. Fortunately, Virscend Education grew its EBIT by 8.3% in the last year, making that debt load look even more manageable. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Virscend Education’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.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So it’s worth checking how much of that EBIT is backed by free cash flow. Over the most recent three years, Virscend Education recorded free cash flow worth 58% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
On this analysis, Virscend Education’s interest cover was a real positive, just like an unsolicited gift of cupcakes from a work colleague. And its apparent ability to handle its debt, based on its EBITDA, is also rather rousing! All these things considered, it appears that Virscend Education can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it’s worth keeping an eye on this one. 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. Take risks, for example – Virscend Education has 3 warning signs we think you should be aware of.
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.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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.
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. Thank you for reading.