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Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 note that Bright Scholar Education Holdings Limited (NYSE:BEDU) 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 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. 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.
How Much Debt Does Bright Scholar Education Holdings Carry?
The image below, which you can click on for greater detail, shows that at August 2020 Bright Scholar Education Holdings had debt of CN¥3.08b, up from CN¥2.17b in one year. But on the other hand it also has CN¥3.41b in cash, leading to a CN¥333.1m net cash position.
A Look At Bright Scholar Education Holdings' Liabilities
The latest balance sheet data shows that Bright Scholar Education Holdings had liabilities of CN¥3.70b due within a year, and liabilities of CN¥4.00b falling due after that. On the other hand, it had cash of CN¥3.41b and CN¥97.0m worth of receivables due within a year. So its liabilities total CN¥4.19b more than the combination of its cash and short-term receivables.
This is a mountain of leverage relative to its market capitalization of CN¥4.46b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution. Despite its noteworthy liabilities, Bright Scholar Education Holdings boasts net cash, so it's fair to say it does not have a heavy debt load!
Also good is that Bright Scholar Education Holdings grew its EBIT at 20% over the last year, further increasing its ability to manage debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Bright Scholar Education Holdings'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.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Bright Scholar Education Holdings 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. Over the last three years, Bright Scholar Education Holdings actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
While Bright Scholar Education Holdings does have more liabilities than liquid assets, it also has net cash of CN¥333.1m. And it impressed us with free cash flow of CN¥341m, being 159% of its EBIT. So we are not troubled with Bright Scholar Education Holdings's debt use. 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. To that end, you should learn about the 3 warning signs we've spotted with Bright Scholar Education Holdings (including 1 which is significant) .
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.
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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