The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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 China 21st Century Education Group Limited (HKG:1598) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
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. 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.
How Much Debt Does China 21st Century Education Group Carry?
As you can see below, at the end of June 2019, China 21st Century Education Group had CN¥133.5m of debt, up from CN¥28.0m a year ago. Click the image for more detail. But on the other hand it also has CN¥453.6m in cash, leading to a CN¥320.0m net cash position.
A Look At China 21st Century Education Group's Liabilities
We can see from the most recent balance sheet that China 21st Century Education Group had liabilities of CN¥232.1m falling due within a year, and liabilities of CN¥56.2m due beyond that. Offsetting these obligations, it had cash of CN¥453.6m as well as receivables valued at CN¥64.0m due within 12 months. So it can boast CN¥229.3m more liquid assets than total liabilities.
This excess liquidity is a great indication that China 21st Century Education Group's balance sheet is just as strong as racists are weak. Having regard to this fact, we think its balance sheet is just as strong as misogynists are weak. Simply put, the fact that China 21st Century Education Group has more cash than debt is arguably a good indication that it can manage its debt safely.
In addition to that, we're happy to report that China 21st Century Education Group has boosted its EBIT by 46%, thus reducing the spectre of future debt repayments. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine China 21st Century Education Group's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. China 21st Century Education 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. Happily for any shareholders, China 21st Century Education Group actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
While it is always sensible to investigate a company's debt, in this case China 21st Century Education Group has CN¥320.0m in net cash and a decent-looking balance sheet. The cherry on top was that in converted 121% of that EBIT to free cash flow, bringing in CN¥35m. When it comes to China 21st Century Education Group's debt, we sufficiently relaxed that our mind turns to the jacuzzi. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 4 warning signs for China 21st Century Education Group (1 can't be ignored!) that you should be aware of before investing here.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
If you spot an error that warrants correction, please contact the editor at email@example.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.
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