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Is Dongyue Group (HKG:189) A Risky Investment?

Simply Wall St

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. 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. As with many other companies Dongyue Group Limited (HKG:189) makes use of debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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 step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Dongyue Group

What Is Dongyue Group's Net Debt?

The image below, which you can click on for greater detail, shows that Dongyue Group had debt of CN¥2.00b at the end of June 2019, a reduction from CN¥2.15b over a year. However, it does have CN¥3.65b in cash offsetting this, leading to net cash of CN¥1.65b.

SEHK:189 Historical Debt, February 4th 2020

How Healthy Is Dongyue Group's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Dongyue Group had liabilities of CN¥5.88b due within 12 months and liabilities of CN¥1.52b due beyond that. Offsetting this, it had CN¥3.65b in cash and CN¥1.34b in receivables that were due within 12 months. So its liabilities total CN¥2.42b more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Dongyue Group is worth CN¥6.66b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. While it does have liabilities worth noting, Dongyue Group also has more cash than debt, so we're pretty confident it can manage its debt safely.

On the other hand, Dongyue Group's EBIT dived 13%, over the last year. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. When analysing debt levels, the balance sheet is the obvious place to start. But it is Dongyue 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. Dongyue 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, Dongyue Group produced sturdy free cash flow equating to 69% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Summing up

While Dongyue Group does have more liabilities than liquid assets, it also has net cash of CN¥1.65b. And it impressed us with free cash flow of CN¥2.3b, being 69% of its EBIT. So we are not troubled with Dongyue Group's debt use. 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. Consider for instance, the ever-present spectre of investment risk. We've identified 1 warning sign with Dongyue Group , and understanding them should be part of your investment process.

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.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. 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.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.