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.' 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 Dongyue Group Limited (HKG:189) does use debt in its business. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Dongyue Group Carry?
The image below, which you can click on for greater detail, shows that Dongyue Group had debt of CN¥624.1m at the end of December 2021, a reduction from CN¥1.90b over a year. However, it does have CN¥5.25b in cash offsetting this, leading to net cash of CN¥4.63b.
How Strong Is Dongyue Group's Balance Sheet?
According to the last reported balance sheet, Dongyue Group had liabilities of CN¥5.25b due within 12 months, and liabilities of CN¥715.1m due beyond 12 months. Offsetting these obligations, it had cash of CN¥5.25b as well as receivables valued at CN¥2.39b due within 12 months. So it actually has CN¥1.68b more liquid assets than total liabilities.
This surplus suggests that Dongyue Group has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Succinctly put, Dongyue Group boasts net cash, so it's fair to say it does not have a heavy debt load!
Even more impressive was the fact that Dongyue Group grew its EBIT by 263% over twelve months. If maintained that growth will make the debt even more manageable in the years ahead. 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 Dongyue Group can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Dongyue Group has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Looking at the most recent three years, Dongyue Group recorded free cash flow of 20% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.
While we empathize with investors who find debt concerning, you should keep in mind that Dongyue Group has net cash of CN¥4.63b, as well as more liquid assets than liabilities. And it impressed us with its EBIT growth of 263% over the last year. So is Dongyue Group's debt a risk? It doesn't seem so to us. 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. For example Dongyue Group has 4 warning signs (and 1 which is significant) we think you should know about.
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.
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.