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

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 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 Dangerous?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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 China Gingko Education Group

What Is China Gingko Education Group's Net Debt?

The chart below, which you can click on for greater detail, shows that China Gingko Education Group had CN¥435.1m in debt in June 2021; about the same as the year before. However, it also had CN¥80.4m in cash, and so its net debt is CN¥354.7m.

How Strong Is China Gingko Education Group's Balance Sheet?

The latest balance sheet data shows that China Gingko Education Group had liabilities of CN¥200.4m due within a year, and liabilities of CN¥373.0m falling due after that. On the other hand, it had cash of CN¥80.4m and CN¥4.05m worth of receivables due within a year. So its liabilities total CN¥488.9m more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of CN¥513.6m, so it does suggest shareholders should keep an eye on China Gingko Education Group's use of debt. 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

With a net debt to EBITDA ratio of 5.7, it's fair to say China Gingko Education Group does have a significant amount of debt. But the good news is that it boasts fairly comforting interest cover of 3.5 times, suggesting it can responsibly service its obligations. The good news is that China Gingko Education Group grew its EBIT a smooth 38% over the last twelve months. Like the milk of human kindness that sort of growth increases resilience, making the company more capable of managing debt. 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 China Gingko 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. 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 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

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 it's pretty decent at growing its EBIT; that's encouraging. Looking at the bigger picture, it seems clear to us that China Gingko Education Group's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example China Gingko Education Group has 4 warning signs (and 2 which make us uncomfortable) we think you should know about.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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.

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