China Electronics Optics Valley Union Holding (HKG:798) Seems To Be Using A Lot Of Debt

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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that China Electronics Optics Valley Union Holding Company Limited (HKG:798) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

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

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

The image below, which you can click on for greater detail, shows that at June 2022 China Electronics Optics Valley Union Holding had debt of CN¥7.08b, up from CN¥5.61b in one year. On the flip side, it has CN¥2.51b in cash leading to net debt of about CN¥4.57b.

A Look At China Electronics Optics Valley Union Holding's Liabilities

We can see from the most recent balance sheet that China Electronics Optics Valley Union Holding had liabilities of CN¥9.14b falling due within a year, and liabilities of CN¥5.01b due beyond that. Offsetting these obligations, it had cash of CN¥2.51b as well as receivables valued at CN¥2.57b due within 12 months. So it has liabilities totalling CN¥9.07b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the CN¥2.56b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, China Electronics Optics Valley Union Holding would likely require a major re-capitalisation if it had to pay its creditors today.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

China Electronics Optics Valley Union Holding has a rather high debt to EBITDA ratio of 5.1 which suggests a meaningful debt load. However, its interest coverage of 4.2 is reasonably strong, which is a good sign. On a slightly more positive note, China Electronics Optics Valley Union Holding grew its EBIT at 13% over the last year, further increasing its ability to manage debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is China Electronics Optics Valley Union Holding's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. 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 recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

On the face of it, China Electronics Optics Valley Union Holding's net debt to EBITDA left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at growing its EBIT; that's encouraging. Overall, it seems to us that China Electronics Optics Valley Union Holding's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 3 warning signs with China Electronics Optics Valley Union Holding (at least 1 which is a bit concerning) , and understanding them should be part of your investment process.

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.