Here's Why China Oriental Group (HKG:581) Has A Meaningful Debt Burden

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 Oriental Group Company Limited (HKG:581) does use debt in its business. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for China Oriental Group

What Is China Oriental Group's Net Debt?

The image below, which you can click on for greater detail, shows that at December 2020 China Oriental Group had debt of CN¥11.6b, up from CN¥6.00b in one year. However, it also had CN¥8.95b in cash, and so its net debt is CN¥2.64b.

How Strong Is China Oriental Group's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that China Oriental Group had liabilities of CN¥20.2b due within 12 months and liabilities of CN¥3.06b due beyond that. Offsetting these obligations, it had cash of CN¥8.95b as well as receivables valued at CN¥4.66b due within 12 months. So its liabilities total CN¥9.70b more than the combination of its cash and short-term receivables.

Given this deficit is actually higher than the company's market capitalization of CN¥7.60b, we think shareholders really should watch China Oriental Group's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

China Oriental Group has net debt of just 1.0 times EBITDA, suggesting it could ramp leverage without breaking a sweat. But the really cool thing is that it actually managed to receive more interest than it paid, over the last year. So it's fair to say it can handle debt like a hotshot teppanyaki chef handles cooking. In fact China Oriental Group's saving grace is its low debt levels, because its EBIT has tanked 58% in the last twelve months. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine China Oriental Group's ability to maintain a healthy balance sheet going forward. 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. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, China Oriental Group's free cash flow amounted to 21% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

To be frank both China Oriental Group's level of total liabilities and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Overall, it seems to us that China Oriental Group'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. To that end, you should learn about the 5 warning signs we've spotted with China Oriental Group (including 2 which shouldn't be ignored) .

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.

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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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