These 4 Measures Indicate That China Education Group Holdings (HKG:839) Is Using Debt Extensively

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.' 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 note that China Education Group Holdings Limited (HKG:839) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for China Education Group Holdings

How Much Debt Does China Education Group Holdings Carry?

You can click the graphic below for the historical numbers, but it shows that China Education Group Holdings had CN¥8.43b of debt in February 2023, down from CN¥8.88b, one year before. However, it also had CN¥5.89b in cash, and so its net debt is CN¥2.53b.

How Strong Is China Education Group Holdings' Balance Sheet?

According to the last reported balance sheet, China Education Group Holdings had liabilities of CN¥8.26b due within 12 months, and liabilities of CN¥8.40b due beyond 12 months. On the other hand, it had cash of CN¥5.89b and CN¥315.0m worth of receivables due within a year. So its liabilities total CN¥10.5b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of CN¥14.7b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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.

With net debt sitting at just 0.96 times EBITDA, China Education Group Holdings is arguably pretty conservatively geared. And this view is supported by the solid interest coverage, with EBIT coming in at 7.2 times the interest expense over the last year. And we also note warmly that China Education Group Holdings grew its EBIT by 19% last year, making its debt load easier to handle. The balance sheet is clearly the area to focus on when you are analysing debt. 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, China Education Group Holdings reported free cash flow worth 15% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

While China Education Group Holdings's conversion of EBIT to free cash flow does give us pause, its EBIT growth rate and net debt to EBITDA suggest it can stay on top of its debt load. Looking at all the angles mentioned above, it does seem to us that China Education Group Holdings is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for China Education Group Holdings you should know about.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.