Is Edvantage Group Holdings (HKG:382) Using Too Much Debt?

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 Edvantage Group Holdings Limited (HKG:382) does use debt in its business. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Edvantage Group Holdings

What Is Edvantage Group Holdings's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of August 2022 Edvantage Group Holdings had CN¥1.66b of debt, an increase on CN¥1.34b, over one year. However, it does have CN¥1.41b in cash offsetting this, leading to net debt of about CN¥251.7m.

A Look At Edvantage Group Holdings' Liabilities

According to the last reported balance sheet, Edvantage Group Holdings had liabilities of CN¥2.17b due within 12 months, and liabilities of CN¥1.48b due beyond 12 months. Offsetting these obligations, it had cash of CN¥1.41b as well as receivables valued at CN¥17.1m due within 12 months. So its liabilities total CN¥2.22b more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Edvantage Group Holdings is worth CN¥3.99b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Edvantage Group Holdings has a low net debt to EBITDA ratio of only 0.36. And its EBIT covers its interest expense a whopping 847 times over. So we're pretty relaxed about its super-conservative use of debt. Another good sign is that Edvantage Group Holdings has been able to increase its EBIT by 25% in twelve months, making it easier to pay down debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Edvantage Group Holdings 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Edvantage Group Holdings recorded free cash flow of 22% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Both Edvantage Group Holdings's ability to to cover its interest expense with its EBIT and its EBIT growth rate gave us comfort that it can handle its debt. On the other hand, its conversion of EBIT to free cash flow makes us a little less comfortable about its debt. Considering this range of data points, we think Edvantage Group Holdings is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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 Edvantage Group Holdings is showing 2 warning signs in our investment analysis , 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.

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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.