China Maple Leaf Educational Systems (HKG:1317) Takes On Some Risk With Its Use Of Debt

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. We can see that China Maple Leaf Educational Systems Limited (HKG:1317) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for China Maple Leaf Educational Systems

What Is China Maple Leaf Educational Systems's Net Debt?

The image below, which you can click on for greater detail, shows that at August 2020 China Maple Leaf Educational Systems had debt of CN¥3.63b, up from CN¥331.0m in one year. On the flip side, it has CN¥1.33b in cash leading to net debt of about CN¥2.30b.

A Look At China Maple Leaf Educational Systems's Liabilities

We can see from the most recent balance sheet that China Maple Leaf Educational Systems had liabilities of CN¥4.58b falling due within a year, and liabilities of CN¥2.06b due beyond that. Offsetting this, it had CN¥1.33b in cash and CN¥154.0m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥5.16b.

This deficit is considerable relative to its market capitalization of CN¥5.18b, so it does suggest shareholders should keep an eye on China Maple Leaf Educational Systems's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its 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 has a debt to EBITDA ratio of 4.0, which signals significant debt, but is still pretty reasonable for most types of business. However, its interest coverage of 1k is very high, suggesting that the interest expense on the debt is currently quite low. Sadly, China Maple Leaf Educational Systems's EBIT actually dropped 8.0% in the last year. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if China Maple Leaf Educational Systems can strengthen its balance sheet over time. 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 company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Happily for any shareholders, China Maple Leaf Educational Systems actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

Even if we have reservations about how easily China Maple Leaf Educational Systems is capable of staying on top of its total liabilities, its interest cover and conversion of EBIT to free cash flow make us think feel relatively unconcerned. We think that China Maple Leaf Educational Systems's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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 - China Maple Leaf Educational Systems has 1 warning sign we think you should be aware of.

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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