Does Edvantage Group Holdings (HKG:382) Have A Healthy Balance Sheet?

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 note that Edvantage Group Holdings Limited (HKG:382) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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 Edvantage Group Holdings

How Much Debt Does Edvantage Group Holdings Carry?

As you can see below, at the end of February 2022, Edvantage Group Holdings had CN¥1.61b of debt, up from CN¥1.42b a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥926.5m, its net debt is less, at about CN¥687.7m.

A Look At Edvantage Group Holdings' Liabilities

We can see from the most recent balance sheet that Edvantage Group Holdings had liabilities of CN¥1.68b falling due within a year, and liabilities of CN¥1.48b due beyond that. Offsetting these obligations, it had cash of CN¥926.5m as well as receivables valued at CN¥24.5m due within 12 months. So it has liabilities totalling CN¥2.21b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of CN¥2.42b, so it does suggest shareholders should keep an eye on Edvantage Group Holdings' 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Edvantage Group Holdings's net debt is only 1.1 times its EBITDA. And its EBIT easily covers its interest expense, being 56.5 times the size. So we're pretty relaxed about its super-conservative use of debt. In addition to that, we're happy to report that Edvantage Group Holdings has boosted its EBIT by 51%, thus reducing the spectre of future debt repayments. 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 Edvantage Group Holdings'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. In the last three years, Edvantage Group Holdings created free cash flow amounting to 11% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

Edvantage Group Holdings's interest cover was a real positive on this analysis, as was its EBIT growth rate. Having said that, its conversion of EBIT to free cash flow somewhat sensitizes us to potential future risks to the balance sheet. Looking at all this data makes us feel a little cautious about Edvantage Group Holdings's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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. Be aware that Edvantage Group Holdings is showing 1 warning sign in our investment analysis , you should know about...

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.