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Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Hailiang Education Group Inc. (NASDAQ:HLG) makes use of debt. But is this debt a concern to shareholders?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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 Hailiang Education Group's Debt?
You can click the graphic below for the historical numbers, but it shows that Hailiang Education Group had CN¥45.5m of debt in June 2021, down from CN¥84.2m, one year before. But on the other hand it also has CN¥756.7m in cash, leading to a CN¥711.2m net cash position.
How Healthy Is Hailiang Education Group's Balance Sheet?
According to the last reported balance sheet, Hailiang Education Group had liabilities of CN¥1.02b due within 12 months, and liabilities of CN¥35.4m due beyond 12 months. Offsetting this, it had CN¥756.7m in cash and CN¥66.2m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥231.0m.
Given Hailiang Education Group has a market capitalization of CN¥3.21b, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. Despite its noteworthy liabilities, Hailiang Education Group boasts net cash, so it's fair to say it does not have a heavy debt load!
In addition to that, we're happy to report that Hailiang Education Group has boosted its EBIT by 35%, thus reducing the spectre of future debt repayments. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Hailiang 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Hailiang 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, Hailiang Education Group actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
While it is always sensible to look at a company's total liabilities, it is very reassuring that Hailiang Education Group has CN¥711.2m in net cash. The cherry on top was that in converted 117% of that EBIT to free cash flow, bringing in CN¥773m. So we don't think Hailiang Education Group's use of debt is risky. 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 instance, we've identified 1 warning sign for Hailiang Education Group that 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.
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.