Here's Why Oriental University City Holdings (H.K.) (HKG:8067) Has A Meaningful Debt Burden

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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 Oriental University City Holdings (H.K.) Limited (HKG:8067) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest 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 Oriental University City Holdings (H.K.)

What Is Oriental University City Holdings (H.K.)'s Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2020 Oriental University City Holdings (H.K.) had CN¥226.5m of debt, an increase on CN¥166.4m, over one year. However, it does have CN¥18.9m in cash offsetting this, leading to net debt of about CN¥207.6m.

How Healthy Is Oriental University City Holdings (H.K.)'s Balance Sheet?

We can see from the most recent balance sheet that Oriental University City Holdings (H.K.) had liabilities of CN¥58.6m falling due within a year, and liabilities of CN¥351.4m due beyond that. Offsetting this, it had CN¥18.9m in cash and CN¥12.5m in receivables that were due within 12 months. So it has liabilities totalling CN¥378.7m more than its cash and near-term receivables, combined.

This deficit casts a shadow over the CN¥240.6m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, Oriental University City Holdings (H.K.) would probably need a major re-capitalization if its creditors were to demand repayment.

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.

Oriental University City Holdings (H.K.) has a rather high debt to EBITDA ratio of 5.4 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 4.7 times, suggesting it can responsibly service its obligations. Sadly, Oriental University City Holdings (H.K.)'s EBIT actually dropped 2.4% in the last year. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Oriental University City Holdings (H.K.) 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Oriental University City Holdings (H.K.) recorded free cash flow worth a fulsome 81% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Our View

To be frank both Oriental University City Holdings (H.K.)'s net debt to EBITDA and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Looking at the bigger picture, it seems clear to us that Oriental University City Holdings (H.K.)'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. However, not all investment risk resides within the balance sheet - far from it. We've identified 3 warning signs with Oriental University City Holdings (H.K.) (at least 1 which makes us a bit uncomfortable) , and understanding them should be part of your investment process.

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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