Is Chen Lin Education Group Holdings (HKG:1593) Using Too Much Debt?

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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. As with many other companies Chen Lin Education Group Holdings Limited (HKG:1593) makes use of debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. 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 think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Chen Lin Education Group Holdings

What Is Chen Lin Education Group Holdings's Net Debt?

The chart below, which you can click on for greater detail, shows that Chen Lin Education Group Holdings had CN¥431.8m in debt in June 2020; about the same as the year before. However, it also had CN¥412.3m in cash, and so its net debt is CN¥19.4m.

A Look At Chen Lin Education Group Holdings's Liabilities

Zooming in on the latest balance sheet data, we can see that Chen Lin Education Group Holdings had liabilities of CN¥226.2m due within 12 months and liabilities of CN¥343.1m due beyond that. Offsetting this, it had CN¥412.3m in cash and CN¥38.6m in receivables that were due within 12 months. So it has liabilities totalling CN¥118.4m more than its cash and near-term receivables, combined.

Given Chen Lin Education Group Holdings has a market capitalization of CN¥1.78b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. Carrying virtually no net debt, Chen Lin Education Group Holdings has a very light debt load indeed.

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).

Looking at its net debt to EBITDA of 0.13 and interest cover of 5.8 times, it seems to us that Chen Lin Education Group Holdings is probably using debt in a pretty reasonable way. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Unfortunately, Chen Lin Education Group Holdings's EBIT flopped 14% over the last four quarters. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. There's no doubt that we learn most about debt from the balance sheet. But it is Chen Lin Education Group Holdings's earnings that will influence how the balance sheet holds up in the future. 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, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, Chen Lin Education Group Holdings recorded free cash flow of 26% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

When it comes to the balance sheet, the standout positive for Chen Lin Education Group Holdings was the fact that it seems able handle its debt, based on its EBITDA, confidently. However, our other observations weren't so heartening. In particular, EBIT growth rate gives us cold feet. When we consider all the factors mentioned above, we do feel a bit cautious about Chen Lin Education Group Holdings's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Consider for instance, the ever-present spectre of investment risk. We've identified 2 warning signs with Chen Lin Education Group Holdings , and understanding them should be part of your investment process.

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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