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. 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. We can see that Minsheng Education Group Company Limited (HKG:1569) does use debt in its business. But is this debt a concern to shareholders?
When Is Debt Dangerous?
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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Minsheng Education Group Carry?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 Minsheng Education Group had CN¥378.1m of debt, an increase on CN¥58.8m, over one year. However, its balance sheet shows it holds CN¥752.8m in cash, so it actually has CN¥374.7m net cash.
How Strong Is Minsheng Education Group's Balance Sheet?
We can see from the most recent balance sheet that Minsheng Education Group had liabilities of CN¥810.7m falling due within a year, and liabilities of CN¥1.77b due beyond that. Offsetting this, it had CN¥752.8m in cash and CN¥6.77m in receivables that were due within 12 months. So it has liabilities totalling CN¥1.82b more than its cash and near-term receivables, combined.
While this might seem like a lot, it is not so bad since Minsheng Education Group has a market capitalization of CN¥4.73b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. While it does have liabilities worth noting, Minsheng Education Group also has more cash than debt, so we're pretty confident it can manage its debt safely.
On top of that, Minsheng Education Group grew its EBIT by 58% over the last twelve months, and that growth will make it easier to handle its 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 Minsheng 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.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Minsheng 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. Over the last three years, Minsheng Education Group reported free cash flow worth 17% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.
While Minsheng Education Group does have more liabilities than liquid assets, it also has net cash of CN¥374.7m. And it impressed us with its EBIT growth of 58% over the last year. So we don't have any problem with Minsheng Education Group's use of debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 2 warning signs for Minsheng Education Group (1 is a bit concerning) you should be aware of.
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 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.
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.