China Education Group Holdings (HKG:839) Seems To Use Debt Quite Sensibly

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. Importantly, China Education Group Holdings Limited (HKG:839) does carry debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for China Education Group Holdings

How Much Debt Does China Education Group Holdings Carry?

As you can see below, at the end of February 2021, China Education Group Holdings had CN¥7.15b of debt, up from CN¥4.27b a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥5.62b, its net debt is less, at about CN¥1.53b.

How Strong Is China Education Group Holdings' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that China Education Group Holdings had liabilities of CN¥5.80b due within 12 months and liabilities of CN¥7.52b due beyond that. Offsetting these obligations, it had cash of CN¥5.62b as well as receivables valued at CN¥131.9m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥7.57b.

Given China Education Group Holdings has a market capitalization of CN¥37.9b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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

China Education Group Holdings's net debt is only 0.96 times its EBITDA. And its EBIT easily covers its interest expense, being 13.4 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On top of that, China Education Group Holdings grew its EBIT by 49% over the last twelve months, and that growth will make it easier to handle its 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 China Education 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, China Education Group Holdings recorded free cash flow of 36% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

The good news is that China Education Group Holdings's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But truth be told we feel its conversion of EBIT to free cash flow does undermine this impression a bit. Taking all this data into account, it seems to us that China Education Group Holdings takes a pretty sensible approach to debt. While that brings some risk, it can also enhance returns for shareholders. 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. We've identified 5 warning signs with China Education Group Holdings (at least 1 which is significant) , 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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