China Ludao Technology (HKG:2023) Has A Pretty Healthy Balance Sheet

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 can see that China Ludao Technology Company Limited (HKG:2023) does use debt in its business. But should shareholders be worried about its use of debt?

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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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 Ludao Technology

What Is China Ludao Technology's Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2020 China Ludao Technology had CN¥275.0m of debt, an increase on CN¥249.2m, over one year. However, it also had CN¥54.4m in cash, and so its net debt is CN¥220.5m.

A Look At China Ludao Technology's Liabilities

According to the last reported balance sheet, China Ludao Technology had liabilities of CN¥520.4m due within 12 months, and liabilities of CN¥12.4m due beyond 12 months. Offsetting this, it had CN¥54.4m in cash and CN¥109.0m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥369.4m.

This is a mountain of leverage relative to its market capitalization of CN¥434.0m. 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.

China Ludao Technology has net debt worth 2.2 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 5.0 times the interest expense. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. It is well worth noting that China Ludao Technology's EBIT shot up like bamboo after rain, gaining 94% in the last twelve months. That'll make it easier to manage its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is China Ludao Technology's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, China Ludao Technology recorded free cash flow of 37% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

On our analysis China Ludao Technology's EBIT growth rate should signal that it won't have too much trouble with its debt. But the other factors we noted above weren't so encouraging. For instance it seems like it has to struggle a bit to handle its total liabilities. When we consider all the factors mentioned above, we do feel a bit cautious about China Ludao Technology's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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. Case in point: We've spotted 2 warning signs for China Ludao Technology you should be aware of.

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. 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.
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