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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Baoye Group Company Limited (HKG:2355) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. 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. 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. When we think about a company's use of debt, we first look at cash and debt together.
What Is Baoye Group's Debt?
As you can see below, at the end of June 2019, Baoye Group had CN¥4.30b of debt, up from CN¥2.17b a year ago. Click the image for more detail. However, its balance sheet shows it holds CN¥5.50b in cash, so it actually has CN¥1.20b net cash.
How Healthy Is Baoye Group's Balance Sheet?
According to the last reported balance sheet, Baoye Group had liabilities of CN¥22.8b due within 12 months, and liabilities of CN¥477.1m due beyond 12 months. Offsetting this, it had CN¥5.50b in cash and CN¥10.9b in receivables that were due within 12 months. So it has liabilities totalling CN¥6.90b more than its cash and near-term receivables, combined.
This deficit casts a shadow over the CN¥2.25b 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, Baoye Group would probably need a major re-capitalization if its creditors were to demand repayment. Given that Baoye Group has more cash than debt, we're pretty confident it can handle its debt, despite the fact that it has a lot of liabilities in total.
Also positive, Baoye Group grew its EBIT by 21% in the last year, and that should make it easier to pay down debt, going forward. There's no doubt that we learn most about debt from the balance sheet. But it is Baoye Group'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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Baoye 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. During the last three years, Baoye Group burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
Although Baoye Group's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of CN¥1.20b. And it impressed us with its EBIT growth of 21% over the last year. Despite its cash we think that Baoye Group seems to struggle to handle its total liabilities, so we are wary of the stock. Over time, share prices tend to follow earnings per share, so if you're interested in Baoye Group, you may well want to click here to check an interactive graph of its earnings per share history.
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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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.