Here's Why Baoye Group (HKG:2355) Has A Meaningful Debt Burden

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.' 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. As with many other companies Baoye Group Company Limited (HKG:2355) makes use of debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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.

Check out our latest analysis for Baoye Group

How Much Debt Does Baoye Group Carry?

You can click the graphic below for the historical numbers, but it shows that as of December 2020 Baoye Group had CN¥5.93b of debt, an increase on CN¥5.63b, over one year. However, its balance sheet shows it holds CN¥8.30b in cash, so it actually has CN¥2.37b net cash.

A Look At Baoye Group's Liabilities

According to the last reported balance sheet, Baoye Group had liabilities of CN¥29.4b due within 12 months, and liabilities of CN¥2.37b due beyond 12 months. Offsetting these obligations, it had cash of CN¥8.30b as well as receivables valued at CN¥11.2b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥12.4b.

The deficiency here weighs heavily on the CN¥1.81b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. After all, Baoye Group would likely require a major re-capitalisation if it had to pay its creditors today. Given that Baoye Group has more cash than debt, we're pretty confident it can handle its debt, despite the fact that it has a lot of liabilities in total.

The good news is that Baoye Group has increased its EBIT by 2.3% over twelve months, which should ease any concerns about debt repayment. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Baoye Group's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Baoye Group may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the most recent three years, Baoye Group recorded free cash flow worth 62% 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.

Summing up

While Baoye Group does have more liabilities than liquid assets, it also has net cash of CN¥2.37b. So although we see some areas for improvement, we're not too worried about Baoye Group's balance sheet. 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. For example, we've discovered 1 warning sign for Baoye Group that you should be aware of before investing here.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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