We Think China New Higher Education Group (HKG:2001) Is Taking Some Risk With Its Debt

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. Importantly, China New Higher Education Group Limited (HKG:2001) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for China New Higher Education Group

What Is China New Higher Education Group's Net Debt?

The image below, which you can click on for greater detail, shows that at August 2024 China New Higher Education Group had debt of CN¥3.52b, up from CN¥2.71b in one year. However, it does have CN¥1.42b in cash offsetting this, leading to net debt of about CN¥2.10b.

How Healthy Is China New Higher Education Group's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that China New Higher Education Group had liabilities of CN¥4.33b due within 12 months and liabilities of CN¥2.57b due beyond that. On the other hand, it had cash of CN¥1.42b and CN¥4.05m worth of receivables due within a year. So it has liabilities totalling CN¥5.49b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the CN¥1.53b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. At the end of the day, China New Higher Education Group would probably need a major re-capitalization if its creditors were to demand repayment.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

China New Higher Education Group's net debt is sitting at a very reasonable 2.2 times its EBITDA, while its EBIT covered its interest expense just 6.8 times last year. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. We saw China New Higher Education Group grow its EBIT by 7.1% in the last twelve months. That's far from incredible but it is a good thing, when it comes to paying off debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine China New Higher Education Group's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

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. Happily for any shareholders, China New Higher Education Group actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

Neither China New Higher Education Group's ability to handle its total liabilities nor its net debt to EBITDA gave us confidence in its ability to take on more debt. But its conversion of EBIT to free cash flow tells a very different story, and suggests some resilience. When we consider all the factors discussed, it seems to us that China New Higher Education Group is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. 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 instance, we've identified 3 warning signs for China New Higher Education Group (1 can't be ignored) you should be aware of.

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.