China Maple Leaf Educational Systems (HKG:1317) Seems To Use Debt Quite Sensibly

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.' 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 Maple Leaf Educational Systems Limited (HKG:1317) 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. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. 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 Maple Leaf Educational Systems

What Is China Maple Leaf Educational Systems's Debt?

You can click the graphic below for the historical numbers, but it shows that as of February 2021 China Maple Leaf Educational Systems had CN¥3.56b of debt, an increase on CN¥324.6m, over one year. However, because it has a cash reserve of CN¥940.6m, its net debt is less, at about CN¥2.62b.

How Strong Is China Maple Leaf Educational Systems' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that China Maple Leaf Educational Systems had liabilities of CN¥3.21b due within 12 months and liabilities of CN¥2.58b due beyond that. Offsetting this, it had CN¥940.6m in cash and CN¥108.1m in receivables that were due within 12 months. So its liabilities total CN¥4.74b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of CN¥4.76b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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.

China Maple Leaf Educational Systems's net debt is 3.7 times its EBITDA, which is a significant but still reasonable amount of leverage. But its EBIT was about 89.4 times its interest expense, implying the company isn't really paying a high cost to maintain that level of debt. Even were the low cost to prove unsustainable, that is a good sign. We saw China Maple Leaf Educational Systems grow its EBIT by 2.1% in the last twelve months. That's far from incredible but it is a good thing, when it comes to paying off debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine China Maple Leaf Educational Systems'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, 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. Over the last three years, China Maple Leaf Educational Systems actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

China Maple Leaf Educational Systems's interest cover was a real positive on this analysis, as was its conversion of EBIT to free cash flow. On the other hand, its level of total liabilities makes us a little less comfortable about its debt. Looking at all this data makes us feel a little cautious about China Maple Leaf Educational Systems's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example - China Maple Leaf Educational Systems has 2 warning signs we think you should be aware of.

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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