Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. As with many other companies Guodian Technology & Environment Group Corporation Limited (HKG:1296) makes use of debt. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Guodian Technology & Environment Group's Debt?
As you can see below, Guodian Technology & Environment Group had CN¥11.6b of debt, at June 2019, which is about the same the year before. You can click the chart for greater detail. However, it also had CN¥4.36b in cash, and so its net debt is CN¥7.27b.
A Look At Guodian Technology & Environment Group's Liabilities
Zooming in on the latest balance sheet data, we can see that Guodian Technology & Environment Group had liabilities of CN¥20.5b due within 12 months and liabilities of CN¥5.40b due beyond that. Offsetting this, it had CN¥4.36b in cash and CN¥13.2b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥8.35b.
The deficiency here weighs heavily on the CN¥1.26b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. At the end of the day, Guodian Technology & Environment Group would probably need a major re-capitalization if its creditors were to demand repayment.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Weak interest cover of 0.65 times and a disturbingly high net debt to EBITDA ratio of 8.9 hit our confidence in Guodian Technology & Environment Group like a one-two punch to the gut. The debt burden here is substantial. Even worse, Guodian Technology & Environment Group saw its EBIT tank 40% over the last 12 months. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Guodian Technology & Environment Group will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Guodian Technology & Environment Group actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
To be frank both Guodian Technology & Environment Group's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Taking into account all the aforementioned factors, it looks like Guodian Technology & Environment Group has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. While Guodian Technology & Environment Group didn't make a statutory profit in the last year, its positive EBIT suggests that profitability might not be far away.Click here to see if its earnings are heading in the right direction, over the medium term.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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