Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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, Virscend Education Company Limited (HKG:1565) does carry debt. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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.
How Much Debt Does Virscend Education Carry?
You can click the graphic below for the historical numbers, but it shows that as of June 2021 Virscend Education had CN¥3.68b of debt, an increase on CN¥2.64b, over one year. However, because it has a cash reserve of CN¥547.8m, its net debt is less, at about CN¥3.13b.
How Strong Is Virscend Education's Balance Sheet?
The latest balance sheet data shows that Virscend Education had liabilities of CN¥2.90b due within a year, and liabilities of CN¥1.95b falling due after that. On the other hand, it had cash of CN¥547.8m and CN¥1.68m worth of receivables due within a year. So it has liabilities totalling CN¥4.30b more than its cash and near-term receivables, combined.
This deficit casts a shadow over the CN¥1.05b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, Virscend Education would probably need a major re-capitalization if its creditors were to demand repayment.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
While we wouldn't worry about Virscend Education's net debt to EBITDA ratio of 5.0, we think its super-low interest cover of 2.3 times is a sign of high leverage. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. Another concern for investors might be that Virscend Education's EBIT fell 12% in the last year. If that's the way things keep going handling the debt load will be like delivering hot coffees on a pogo stick. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Virscend Education 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.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Virscend Education saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.
To be frank both Virscend Education's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. And even its net debt to EBITDA fails to inspire much confidence. We think the chances that Virscend Education has too much debt a very significant. To our minds, that means the stock is rather high risk, and probably one to avoid; but to each their own (investing) style. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Be aware that Virscend Education is showing 5 warning signs in our investment analysis , and 1 of those is concerning...
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.
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.
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