These 4 Measures Indicate That China Xinhua Education Group (HKG:2779) Is Using Debt Safely

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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that China Xinhua Education Group Limited (HKG:2779) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

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. If things get really bad, the lenders can take control of the business. 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, 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for China Xinhua Education Group

How Much Debt Does China Xinhua Education Group Carry?

The image below, which you can click on for greater detail, shows that China Xinhua Education Group had debt of CN¥316.0m at the end of December 2020, a reduction from CN¥330.0m over a year. But it also has CN¥890.8m in cash to offset that, meaning it has CN¥574.9m net cash.

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

Zooming in on the latest balance sheet data, we can see that China Xinhua Education Group had liabilities of CN¥463.9m due within 12 months and liabilities of CN¥266.0m due beyond that. Offsetting these obligations, it had cash of CN¥890.8m as well as receivables valued at CN¥904.1m due within 12 months. So it can boast CN¥1.07b more liquid assets than total liabilities.

This excess liquidity is a great indication that China Xinhua Education Group's balance sheet is almost as strong as Fort Knox. On this view, lenders should feel as safe as the beloved of a black-belt karate master. Succinctly put, China Xinhua Education Group boasts net cash, so it's fair to say it does not have a heavy debt load!

Another good sign is that China Xinhua Education Group has been able to increase its EBIT by 28% in twelve months, making it easier to pay down debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if China Xinhua Education Group can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. While China Xinhua 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. In the last three years, China Xinhua Education Group's free cash flow amounted to 43% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that China Xinhua Education Group has net cash of CN¥574.9m, as well as more liquid assets than liabilities. And it impressed us with its EBIT growth of 28% over the last year. So is China Xinhua Education Group's debt a risk? It doesn't seem so to us. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Be aware that China Xinhua Education Group is showing 1 warning sign in our investment analysis , you should know about...

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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