These 4 Measures Indicate That Scholar Education Group (HKG:1769) Is Using Debt Safely

Simply Wall St
May 10, 2022
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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 note that Scholar Education Group (HKG:1769) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Scholar Education Group

How Much Debt Does Scholar Education Group Carry?

As you can see below, Scholar Education Group had CN¥30.0m of debt at December 2021, down from CN¥54.4m a year prior. However, it does have CN¥391.8m in cash offsetting this, leading to net cash of CN¥361.8m.

SEHK:1769 Debt to Equity History May 10th 2022

How Healthy Is Scholar Education Group's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Scholar Education Group had liabilities of CN¥323.4m due within 12 months and liabilities of CN¥119.6m due beyond that. Offsetting this, it had CN¥391.8m in cash and CN¥6.66m in receivables that were due within 12 months. So it has liabilities totalling CN¥44.6m more than its cash and near-term receivables, combined.

Since publicly traded Scholar Education Group shares are worth a total of CN¥243.0m, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. While it does have liabilities worth noting, Scholar Education Group also has more cash than debt, so we're pretty confident it can manage its debt safely.

Notably, Scholar Education Group's EBIT launched higher than Elon Musk, gaining a whopping 479% on last year. 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 Scholar 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Scholar Education Group has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Happily for any shareholders, Scholar Education Group actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Summing up

Although Scholar Education Group's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of CN¥361.8m. And it impressed us with free cash flow of CN¥40m, being 166% of its EBIT. So we don't think Scholar Education Group's use of debt is risky. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Scholar Education Group is showing 3 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.

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