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'. 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 can see that Shentong Robot Education Group Company Limited (HKG:8206) does use debt in its business. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Shentong Robot Education Group's Debt?
You can click the graphic below for the historical numbers, but it shows that as of September 2019 Shentong Robot Education Group had HK$110.3m of debt, an increase on HK$107, over one year. But it also has HK$236.1m in cash to offset that, meaning it has HK$125.8m net cash.
How Strong Is Shentong Robot Education Group's Balance Sheet?
The latest balance sheet data shows that Shentong Robot Education Group had liabilities of HK$308.5m due within a year, and liabilities of HK$99.5m falling due after that. Offsetting this, it had HK$236.1m in cash and HK$31.6m in receivables that were due within 12 months. So it has liabilities totalling HK$140.3m more than its cash and near-term receivables, combined.
This deficit isn't so bad because Shentong Robot Education Group is worth HK$559.2m, 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. Despite its noteworthy liabilities, Shentong Robot Education Group boasts net cash, so it's fair to say it does not have a heavy debt load!
The good news is that Shentong Robot Education Group has increased its EBIT by 5.4% over twelve months, which should ease any concerns about debt repayment. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Shentong Robot Education 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. Shentong Robot 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. During the last three years, Shentong Robot Education Group generated free cash flow amounting to a very robust 94% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.
Although Shentong Robot Education Group's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of HK$125.8m. And it impressed us with free cash flow of HK$90m, being 94% of its EBIT. So we don't think Shentong Robot Education Group's use of debt is risky. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Consider for instance, the ever-present spectre of investment risk. We've identified 4 warning signs with Shentong Robot Education 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 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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