Is China Dongxiang (Group) (HKG:3818) A Risky Investment?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, China Dongxiang (Group) Co., Ltd. (HKG:3818) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for China Dongxiang (Group)

What Is China Dongxiang (Group)'s Net Debt?

The image below, which you can click on for greater detail, shows that China Dongxiang (Group) had debt of CN¥126.6m at the end of March 2021, a reduction from CN¥246.3m over a year. However, its balance sheet shows it holds CN¥5.38b in cash, so it actually has CN¥5.25b net cash.

How Strong Is China Dongxiang (Group)'s Balance Sheet?

We can see from the most recent balance sheet that China Dongxiang (Group) had liabilities of CN¥721.3m falling due within a year, and liabilities of CN¥380.6m due beyond that. Offsetting this, it had CN¥5.38b in cash and CN¥701.5m in receivables that were due within 12 months. So it can boast CN¥4.98b more liquid assets than total liabilities.

This luscious liquidity implies that China Dongxiang (Group)'s balance sheet is sturdy like a giant sequoia tree. On this view, lenders should feel as safe as the beloved of a black-belt karate master. Simply put, the fact that China Dongxiang (Group) has more cash than debt is arguably a good indication that it can manage its debt safely.

Better yet, China Dongxiang (Group) grew its EBIT by 293% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine China Dongxiang (Group)'s ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. China Dongxiang (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 last three years, China Dongxiang (Group) recorded negative free cash flow, in total. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that China Dongxiang (Group) has net cash of CN¥5.25b, as well as more liquid assets than liabilities. And we liked the look of last year's 293% year-on-year EBIT growth. So we don't think China Dongxiang (Group)'s use of debt is risky. 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. For example, we've discovered 4 warning signs for China Dongxiang (Group) (2 make us uncomfortable!) that you should be aware of before investing here.

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.

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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. 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.
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