China Electronics Optics Valley Union Holding (HKG:798) Has A Somewhat Strained Balance Sheet

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies China Electronics Optics Valley Union Holding Company Limited (HKG:798) makes use of debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

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. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for China Electronics Optics Valley Union Holding

What Is China Electronics Optics Valley Union Holding's Debt?

The image below, which you can click on for greater detail, shows that at June 2023 China Electronics Optics Valley Union Holding had debt of CN¥7.53b, up from CN¥7.08b in one year. However, because it has a cash reserve of CN¥1.68b, its net debt is less, at about CN¥5.85b.

How Strong Is China Electronics Optics Valley Union Holding's Balance Sheet?

We can see from the most recent balance sheet that China Electronics Optics Valley Union Holding had liabilities of CN¥9.13b falling due within a year, and liabilities of CN¥5.26b due beyond that. On the other hand, it had cash of CN¥1.68b and CN¥3.57b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥9.14b.

This deficit casts a shadow over the CN¥2.46b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. At the end of the day, China Electronics Optics Valley Union Holding would probably need a major re-capitalization if its creditors were to demand repayment.

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.

China Electronics Optics Valley Union Holding has a debt to EBITDA ratio of 4.7 and its EBIT covered its interest expense 5.2 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Importantly, China Electronics Optics Valley Union Holding grew its EBIT by 39% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since China Electronics Optics Valley Union Holding will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. 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 Electronics Optics Valley Union Holding reported free cash flow worth 9.1% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

Mulling over China Electronics Optics Valley Union Holding's attempt at staying on top of its total liabilities, we're certainly not enthusiastic. But at least it's pretty decent at growing its EBIT; that's encouraging. Overall, we think it's fair to say that China Electronics Optics Valley Union Holding has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. 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 4 warning signs for China Electronics Optics Valley Union Holding (1 is significant) you should be aware of.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.