We Think iQIYI (NASDAQ:IQ) Is Taking Some Risk With Its Debt

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.' 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. We can see that iQIYI, Inc. (NASDAQ:IQ) does use debt in its business. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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.

See our latest analysis for iQIYI

How Much Debt Does iQIYI Carry?

As you can see below, at the end of March 2023, iQIYI had CN¥23.2b of debt, up from CN¥17.8b a year ago. Click the image for more detail. However, it does have CN¥5.20b in cash offsetting this, leading to net debt of about CN¥18.0b.

A Look At iQIYI's Liabilities

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. Offsetting this, it had CN¥5.20b in cash and CN¥2.89b in receivables that were due within 12 months. So it has liabilities totalling CN¥33.3b more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of CN¥36.7b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

iQIYI's net debt is sitting at a very reasonable 1.8 times its EBITDA, while its EBIT covered its interest expense just 3.3 times last year. 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. 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 iQIYI 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. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, iQIYI recorded free cash flow worth a fulsome 84% of its EBIT, which is stronger than we'd usually 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 the good news is it seems to be able to convert EBIT to free cash flow with ease. 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. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example iQIYI has 3 warning signs (and 1 which is a bit unpleasant) we think you should know about.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.