Is Shanghai Gench Education Group (HKG:1525) Using Too Much Debt?

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. We can see that Shanghai Gench Education Group Limited (HKG:1525) does use debt in its business. But the real question is whether this debt is making the company risky.

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When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

How Much Debt Does Shanghai Gench Education Group Carry?

As you can see below, at the end of December 2024, Shanghai Gench Education Group had CN¥829.9m of debt, up from CN¥759.4m a year ago. Click the image for more detail. On the flip side, it has CN¥803.6m in cash leading to net debt of about CN¥26.4m.

How Healthy Is Shanghai Gench Education Group's Balance Sheet?

According to the last reported balance sheet, Shanghai Gench Education Group had liabilities of CN¥979.0m due within 12 months, and liabilities of CN¥679.1m due beyond 12 months. Offsetting these obligations, it had cash of CN¥803.6m as well as receivables valued at CN¥11.7m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥842.8m.

This is a mountain of leverage relative to its market capitalization of CN¥1.02b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

View our latest analysis for Shanghai Gench Education Group

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.

With debt at a measly 0.067 times EBITDA and EBIT covering interest a whopping 18.4 times, it's clear that Shanghai Gench Education Group is not a desperate borrower. Indeed relative to its earnings its debt load seems light as a feather. In fact Shanghai Gench Education Group's saving grace is its low debt levels, because its EBIT has tanked 21% in the last twelve months. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Shanghai Gench Education Group will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the most recent three years, Shanghai Gench Education 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.

Our View

We feel some trepidation about Shanghai Gench Education Group's difficulty EBIT growth rate, but we've got positives to focus on, too. To wit both its interest cover and net debt to EBITDA were encouraging signs. We think that Shanghai Gench Education Group'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. Given Shanghai Gench Education Group has a strong balance sheet is profitable and pays a dividend, it would be good to know how fast its dividends are growing, if at all. You can find out instantly by clicking this link.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.