We Think China Oriental Group (HKG:581) Is Taking Some Risk With Its 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.' 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 note that China Oriental Group Company Limited (HKG:581) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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.

Check out 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 2021 China Oriental Group had debt of CN¥14.0b, up from CN¥11.6b in one year. On the flip side, it has CN¥12.0b in cash leading to net debt of about CN¥1.98b.

How Strong Is China Oriental Group's Balance Sheet?

We can see from the most recent balance sheet that China Oriental Group had liabilities of CN¥26.6b falling due within a year, and liabilities of CN¥2.45b due beyond that. Offsetting this, it had CN¥12.0b in cash and CN¥4.97b in receivables that were due within 12 months. So it has liabilities totalling CN¥12.0b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the CN¥7.20b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, China Oriental Group would likely require a major re-capitalisation if it had to pay its creditors today.

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 Oriental Group has a low debt to EBITDA ratio of only 0.49. 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. Better yet, China Oriental Group grew its EBIT by 105% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if China Oriental 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.

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 Oriental Group 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

To be frank both China Oriental Group's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making China Oriental Group stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 1 warning sign for China Oriental Group 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. 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.