China Ludao Technology (HKG:2023) Takes On Some Risk With Its Use Of 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.' 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 the real question is whether this debt is making the company risky.

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, 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.

See our latest analysis for China Ludao Technology

What Is China Ludao Technology's Net Debt?

The image below, which you can click on for greater detail, shows that at December 2023 China Ludao Technology had debt of CN¥688.5m, up from CN¥597.3m in one year. On the flip side, it has CN¥32.5m in cash leading to net debt of about CN¥656.0m.

How Strong Is China Ludao Technology's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that China Ludao Technology had liabilities of CN¥648.8m due within 12 months and liabilities of CN¥330.7m due beyond that. Offsetting these obligations, it had cash of CN¥32.5m as well as receivables valued at CN¥221.8m due within 12 months. So it has liabilities totalling CN¥725.2m more than its cash and near-term receivables, combined.

This deficit casts a shadow over the CN¥450.0m company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, China Ludao Technology would likely require a major re-capitalisation if it had to pay its creditors today.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

With a net debt to EBITDA ratio of 9.0, it's fair to say China Ludao Technology does have a significant amount of debt. However, its interest coverage of 5.8 is reasonably strong, which is a good sign. Notably, China Ludao Technology's EBIT launched higher than Elon Musk, gaining a whopping 234% on last year. There's no doubt that we learn most about debt from the balance sheet. But it is China Ludao Technology's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, China Ludao Technology saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

On the face of it, China Ludao Technology's conversion of EBIT to free cash flow left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. We're quite clear that we consider China Ludao Technology to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 2 warning signs for China Ludao Technology (1 is concerning) you should be aware of.

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.