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.' 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 China Electronics Optics Valley Union Holding Company Limited (HKG:798) 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. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for China Electronics Optics Valley Union Holding

How Much Debt Does China Electronics Optics Valley Union Holding Carry?

As you can see below, China Electronics Optics Valley Union Holding had CN¥6.10b of debt, at December 2021, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has CN¥2.41b in cash leading to net debt of about CN¥3.70b.

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

Zooming in on the latest balance sheet data, we can see that China Electronics Optics Valley Union Holding had liabilities of CN¥9.13b due within 12 months and liabilities of CN¥3.67b due beyond that. On the other hand, it had cash of CN¥2.41b and CN¥2.53b worth of receivables due within a year. So its liabilities total CN¥7.86b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the CN¥2.29b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. 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's debt is 3.9 times its EBITDA, and its EBIT cover its interest expense 4.4 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. On a lighter note, we note that China Electronics Optics Valley Union Holding grew its EBIT by 30% in the last year. If sustained, this growth should make that debt evaporate like a scarce drinking water during an unnaturally hot summer. When analysing debt levels, the balance sheet is the obvious place to start. But it is China Electronics Optics Valley Union Holding's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, China Electronics Optics Valley Union Holding reported free cash flow worth 16% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish 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 on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Looking at the bigger picture, it seems clear to us that China Electronics Optics Valley Union Holding's use of debt is creating risks for the company. 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 example, we've discovered 3 warning signs for China Electronics Optics Valley Union Holding (1 can't be ignored!) that you should be aware of before investing here.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.