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.' 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. Importantly, Virscend Education Company Limited (HKG:1565) does carry debt. But is this debt a concern to shareholders?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. When we think about a company's use of debt, we first look at cash and debt together.
What Is Virscend Education's Debt?
As you can see below, at the end of June 2019, Virscend Education had CN¥1.22b of debt, up from CN¥873.5m a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥541.8m, its net debt is less, at about CN¥677.7m.
How Healthy Is Virscend Education's Balance Sheet?
According to the last reported balance sheet, Virscend Education had liabilities of CN¥1.48b due within 12 months, and liabilities of CN¥1.09b due beyond 12 months. On the other hand, it had cash of CN¥541.8m and CN¥290.4m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥1.75b.
While this might seem like a lot, it is not so bad since Virscend Education has a market capitalization of CN¥6.20b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Virscend Education has net debt of just 1.2 times EBITDA, indicating that it is certainly not a reckless borrower. And this view is supported by the solid interest coverage, with EBIT coming in at 8.5 times the interest expense over the last year. The good news is that Virscend Education has increased its EBIT by 8.3% over twelve months, which should ease any concerns about debt repayment. 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 Virscend Education's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Virscend Education produced sturdy free cash flow equating to 58% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
We feel that Virscend Education's solid interest cover was really heart warming, like a mid-winter fair trade hot chocolate in a tasteful alpine chalet. And its apparent ability to to convert EBIT to free cash flow is also rather rousing! Looking at all the aforementioned factors together, it strikes us that Virscend Education can handle its debt fairly comfortably. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Virscend Education insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.
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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