Is iQIYI (NASDAQ:IQ) A Risky Investment?

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. We can see that iQIYI, Inc. (NASDAQ:IQ) does use debt in its business. But is this debt a concern to shareholders?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth 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.

See our latest analysis for iQIYI

What Is iQIYI's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2023 iQIYI had CN¥23.2b of debt, an increase on CN¥17.8b, over one year. However, because it has a cash reserve of CN¥5.20b, its net debt is less, at about CN¥18.0b.

How Healthy Is iQIYI's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that iQIYI had liabilities of CN¥27.7b due within 12 months and liabilities of CN¥13.7b due beyond that. On the other hand, it had cash of CN¥5.20b and CN¥2.89b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥33.3b.

This is a mountain of leverage relative to its market capitalization of CN¥36.5b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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).

iQIYI has net debt worth 1.8 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 3.3 times the interest expense. In large part that's due to the company's significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. We also note that iQIYI improved its EBIT from a last year's loss to a positive CN¥2.1b. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine iQIYI's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. During the last year, iQIYI generated free cash flow amounting to a very robust 86% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Our View

Neither iQIYI's ability to cover its interest expense with its EBIT nor its level of total liabilities gave us confidence in its ability to take on more debt. But its conversion of EBIT to free cash flow tells a very different story, and suggests some resilience. We think that iQIYI's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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 example iQIYI has 3 warning signs (and 1 which is significant) we think you should know about.

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. 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.