Is Hope Education Group (HKG:1765) A Risky Investment?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Hope Education Group Co., Ltd. (HKG:1765) does carry debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. 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. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Hope Education Group

What Is Hope Education Group's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of August 2021 Hope Education Group had CN¥5.28b of debt, an increase on CN¥3.23b, over one year. However, it also had CN¥4.47b in cash, and so its net debt is CN¥808.4m.

How Strong Is Hope Education Group's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Hope Education Group had liabilities of CN¥6.88b due within 12 months and liabilities of CN¥5.18b due beyond that. On the other hand, it had cash of CN¥4.47b and CN¥1.05b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥6.54b.

This is a mountain of leverage relative to its market capitalization of CN¥8.76b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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 0.83 and interest cover of 3.5 times, it seems to us that Hope Education Group is probably using debt in a pretty reasonable way. So we'd recommend keeping a close eye on the impact financing costs are having on the business. Notably, Hope Education Group's EBIT launched higher than Elon Musk, gaining a whopping 108% on last year. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Hope Education Group 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. In the last three years, Hope Education Group's free cash flow amounted to 23% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

On our analysis Hope Education Group's EBIT growth rate should signal that it won't have too much trouble with its debt. However, our other observations weren't so heartening. For instance it seems like it has to struggle a bit to cover its interest expense with its EBIT. When we consider all the factors mentioned above, we do feel a bit cautious about Hope Education Group's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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. We've identified 4 warning signs with Hope Education Group , and understanding them should be part of your investment process.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.