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.' 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 note that China Education Group Holdings Limited (HKG:839) does have debt on its balance sheet. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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.

Check out our latest analysis for China Education Group Holdings

What Is China Education Group Holdings's Debt?

As you can see below, at the end of February 2022, China Education Group Holdings had CN¥8.88b of debt, up from CN¥7.15b a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥5.01b, its net debt is less, at about CN¥3.87b.

How Healthy Is China Education Group Holdings' Balance Sheet?

According to the last reported balance sheet, China Education Group Holdings had liabilities of CN¥8.00b due within 12 months, and liabilities of CN¥8.33b due beyond 12 months. Offsetting these obligations, it had cash of CN¥5.01b as well as receivables valued at CN¥374.8m due within 12 months. So it has liabilities totalling CN¥10.9b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of CN¥14.1b, so it does suggest shareholders should keep an eye on China Education Group Holdings' use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

China Education Group Holdings's net debt to EBITDA ratio of about 1.8 suggests only moderate use of debt. And its strong interest cover of 10.1 times, makes us even more comfortable. We note that China Education Group Holdings grew its EBIT by 27% in the last year, and that should make it easier to pay down debt, going forward. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if China Education Group Holdings can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, China Education Group Holdings reported free cash flow worth 2.2% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

We feel some trepidation about China Education Group Holdings's difficulty conversion of EBIT to free cash flow, but we've got positives to focus on, too. To wit both its EBIT growth rate and interest cover were encouraging signs. Looking at all the angles mentioned above, it does seem to us that China Education Group Holdings is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 2 warning signs for China Education Group Holdings that you should be aware of before investing here.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.