Huali University Group (HKG:1756) Has A Somewhat Strained Balance Sheet

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.' 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. As with many other companies Huali University Group Limited (HKG:1756) makes use of debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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.

Check out our latest analysis for Huali University Group

What Is Huali University Group's Net Debt?

The image below, which you can click on for greater detail, shows that at August 2020 Huali University Group had debt of CN¥1.77b, up from CN¥1.08b in one year. However, because it has a cash reserve of CN¥865.1m, its net debt is less, at about CN¥902.9m.

How Strong Is Huali University Group's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Huali University Group had liabilities of CN¥715.1m due within 12 months and liabilities of CN¥1.67b due beyond that. On the other hand, it had cash of CN¥865.1m and CN¥29.3m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥1.49b.

While this might seem like a lot, it is not so bad since Huali University Group has a market capitalization of CN¥2.97b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Huali University Group's net debt of 2.0 times EBITDA suggests graceful use of debt. And the alluring interest cover (EBIT of 8.3 times interest expense) certainly does not do anything to dispel this impression. Importantly, Huali University Group grew its EBIT by 31% over the last twelve months, and that growth will make it easier to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Huali University 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.

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. During the last three years, Huali University Group burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

Neither Huali University Group's ability to convert EBIT to free cash flow nor its level of total liabilities gave us confidence in its ability to take on more debt. But its EBIT growth rate tells a very different story, and suggests some resilience. Looking at all the angles mentioned above, it does seem to us that Huali University Group is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. Consider risks, for instance. Every company has them, and we've spotted 2 warning signs for Huali University Group you should know about.

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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