Is China Ludao Technology (HKG:2023) A Risky Investment?

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.' 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 China Ludao Technology Company Limited (HKG:2023) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt A Problem?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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. The first step when considering a company's debt levels is to consider its 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 June 2023 China Ludao Technology had debt of CN¥686.5m, up from CN¥485.7m in one year. However, it does have CN¥35.7m in cash offsetting this, leading to net debt of about CN¥650.8m.

How Healthy Is China Ludao Technology's Balance Sheet?

According to the last reported balance sheet, China Ludao Technology had liabilities of CN¥220.9m due within 12 months, and liabilities of CN¥560.8m due beyond 12 months. Offsetting these obligations, it had cash of CN¥35.7m as well as receivables valued at CN¥271.7m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥474.4m.

Given this deficit is actually higher than the company's market capitalization of CN¥438.6m, we think shareholders really should watch China Ludao Technology's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

China Ludao Technology shareholders face the double whammy of a high net debt to EBITDA ratio (16.7), and fairly weak interest coverage, since EBIT is just 1.9 times the interest expense. The debt burden here is substantial. On the other hand, China Ludao Technology grew its EBIT by 25% in the last year. If it can maintain that kind of improvement, its debt load will begin to melt away like glaciers in a warming world. 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.

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 Ludao Technology saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

On the face of it, China Ludao Technology's net debt to EBITDA left us tentative about the stock, and its conversion of EBIT to free cash flow 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. Overall, it seems to us that China Ludao Technology's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example China Ludao Technology has 3 warning signs (and 1 which shouldn't be ignored) we think you should know about.

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. 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.