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

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 is this debt a concern to shareholders?

When Is Debt Dangerous?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for China Gingko Education Group

How Much Debt Does China Gingko Education Group Carry?

As you can see below, China Gingko Education Group had CN¥400.5m of debt, at December 2022, which is about the same as the year before. You can click the chart for greater detail. However, it also had CN¥202.0m in cash, and so its net debt is CN¥198.5m.

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

According to the last reported balance sheet, China Gingko Education Group had liabilities of CN¥499.5m due within 12 months, and liabilities of CN¥272.7m due beyond 12 months. Offsetting this, it had CN¥202.0m in cash and CN¥14.8m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥555.4m.

When you consider that this deficiency exceeds the company's CN¥420.0m market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive 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.

While China Gingko Education Group's low debt to EBITDA ratio of 1.4 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 3.8 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. Notably, China Gingko Education Group's EBIT launched higher than Elon Musk, gaining a whopping 119% on last year. 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 recorded negative free cash flow, in total. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Our View

On the face of it, China Gingko Education Group's conversion of EBIT to free cash flow left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Once we consider all the factors above, together, it seems to us that China Gingko Education Group's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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. We've identified 2 warning signs with China Gingko Education Group (at least 1 which is concerning) , 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.