These 4 Measures Indicate That China Electronics Optics Valley Union Holding (HKG:798) Is Using Debt In A Risky Way

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.' 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. Importantly, China Electronics Optics Valley Union Holding Company Limited (HKG:798) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

View 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 December 2020 China Electronics Optics Valley Union Holding had debt of CN¥5.88b, up from CN¥5.04b in one year. However, it also had CN¥2.19b in cash, and so its net debt is CN¥3.69b.

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

According to the last reported balance sheet, China Electronics Optics Valley Union Holding had liabilities of CN¥8.73b due within 12 months, and liabilities of CN¥2.70b due beyond 12 months. Offsetting this, it had CN¥2.19b in cash and CN¥2.36b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥6.87b.

The deficiency here weighs heavily on the CN¥2.67b 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'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.

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 4.0 is reasonably strong, which is a good sign. Given the debt load, it's hardly ideal that China Electronics Optics Valley Union Holding's EBIT was pretty flat over the last twelve months. There's no doubt that we learn most about debt from the balance sheet. 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into 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 conversion of EBIT to free cash flow 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 its EBIT growth rate is not so bad. After considering the datapoints discussed, we think China Electronics Optics Valley Union Holding has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. 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. For example, we've discovered 3 warning signs for China Electronics Optics Valley Union Holding (1 shouldn't be ignored!) that you should be aware of before investing here.

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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