The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. Importantly, Dadi Early-Childhood Education Group Limited (GTSM:8437) does carry debt. But should shareholders be worried about its use of debt?
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 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. 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. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Dadi Early-Childhood Education Group's Net Debt?
The image below, which you can click on for greater detail, shows that at June 2020 Dadi Early-Childhood Education Group had debt of NT$722.3m, up from NT$465.9m in one year. But on the other hand it also has NT$1.57b in cash, leading to a NT$849.0m net cash position.
A Look At Dadi Early-Childhood Education Group's Liabilities
The latest balance sheet data shows that Dadi Early-Childhood Education Group had liabilities of NT$1.28b due within a year, and liabilities of NT$120.1m falling due after that. On the other hand, it had cash of NT$1.57b and NT$471.6m worth of receivables due within a year. So it can boast NT$647.0m more liquid assets than total liabilities.
This short term liquidity is a sign that Dadi Early-Childhood Education Group could probably pay off its debt with ease, as its balance sheet is far from stretched. Succinctly put, Dadi Early-Childhood Education Group boasts net cash, so it's fair to say it does not have a heavy debt load!
In fact Dadi Early-Childhood Education Group's saving grace is its low debt levels, because its EBIT has tanked 34% in the last twelve months. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Dadi Early-Childhood Education Group can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. Dadi Early-Childhood Education Group may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. In the last three years, Dadi Early-Childhood Education Group's free cash flow amounted to 43% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
While we empathize with investors who find debt concerning, you should keep in mind that Dadi Early-Childhood Education Group has net cash of NT$849.0m, as well as more liquid assets than liabilities. So we don't have any problem with Dadi Early-Childhood Education Group's use of debt. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 2 warning signs for Dadi Early-Childhood Education Group (1 can't be ignored) you should be aware of.
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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