Stock Analysis

These 4 Measures Indicate That China Baoan Group (SZSE:000009) Is Using Debt Extensively

SZSE:000009
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Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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. Importantly, China Baoan Group Co., Ltd. (SZSE:000009) does carry debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for China Baoan Group

How Much Debt Does China Baoan Group Carry?

As you can see below, at the end of March 2024, China Baoan Group had CN¥17.8b of debt, up from CN¥17.1b a year ago. Click the image for more detail. However, it also had CN¥11.5b in cash, and so its net debt is CN¥6.28b.

debt-equity-history-analysis
SZSE:000009 Debt to Equity History August 21st 2024

How Healthy Is China Baoan Group's Balance Sheet?

According to the last reported balance sheet, China Baoan Group had liabilities of CN¥15.2b due within 12 months, and liabilities of CN¥15.5b due beyond 12 months. Offsetting this, it had CN¥11.5b in cash and CN¥6.18b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥13.0b.

This is a mountain of leverage relative to its market capitalization of CN¥19.5b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

China Baoan Group has net debt worth 1.8 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 5.2 times the interest expense. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. If China Baoan Group can keep growing EBIT at last year's rate of 18% over the last year, then it will find its debt load easier to manage. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since China Baoan Group 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. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, China Baoan Group burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

China Baoan Group's struggle to convert EBIT to free cash flow had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. For example its EBIT growth rate was refreshing. When we consider all the factors discussed, it seems to us that China Baoan Group is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for China Baoan Group you should know about.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.