These 4 Measures Indicate That China Gingko Education Group (HKG:1851) Is Using Debt Extensively

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.' 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. We can see that China Gingko Education Group Company Limited (HKG:1851) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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 examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for China Gingko Education Group

What Is China Gingko Education Group's Debt?

As you can see below, China Gingko Education Group had CN¥398.4m of debt at December 2020, down from CN¥423.7m a year prior. However, it does have CN¥152.5m in cash offsetting this, leading to net debt of about CN¥245.8m.

A Look At China Gingko Education Group's Liabilities

According to the last reported balance sheet, China Gingko Education Group had liabilities of CN¥277.8m due within 12 months, and liabilities of CN¥380.1m due beyond 12 months. On the other hand, it had cash of CN¥152.5m and CN¥4.29m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥501.1m.

This deficit is considerable relative to its market capitalization of CN¥633.3m, so it does suggest shareholders should keep an eye on China Gingko Education Group's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its 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).

China Gingko Education Group has a rather high debt to EBITDA ratio of 5.4 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 5.2 times, suggesting it can responsibly service its obligations. Unfortunately, China Gingko Education Group saw its EBIT slide 6.1% in the last twelve months. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. When analysing debt levels, the balance sheet is the obvious place to start. But it is China Gingko Education Group's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, China Gingko Education Group 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.

Our View

On the face of it, China Gingko Education Group's net debt to EBITDA left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But at least its interest cover is not so bad. We're quite clear that we consider China Gingko Education Group to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. To that end, you should learn about the 4 warning signs we've spotted with China Gingko Education Group (including 2 which are potentially serious) .

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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This article by Simply Wall St is general in nature. 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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