These 4 Measures Indicate That China Oriental Group (HKG:581) Is Using Debt Reasonably Well

Simply Wall St
Simply Wall St.

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that China Oriental Group Company Limited (HKG:581) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, 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 think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for China Oriental Group

What Is China Oriental Group's Net Debt?

The image below, which you can click on for greater detail, shows that at June 2019 China Oriental Group had debt of CN¥3.98b, up from CN¥1.70b in one year. However, its balance sheet shows it holds CN¥11.5b in cash, so it actually has CN¥7.55b net cash.

SEHK:581 Historical Debt March 27th 2020
SEHK:581 Historical Debt March 27th 2020

How Strong Is China Oriental Group's Balance Sheet?

According to the last reported balance sheet, China Oriental Group had liabilities of CN¥12.6b due within 12 months, and liabilities of CN¥1.03b due beyond 12 months. Offsetting this, it had CN¥11.5b in cash and CN¥2.85b in receivables that were due within 12 months. So it actually has CN¥731.1m more liquid assets than total liabilities.

This surplus suggests that China Oriental Group has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Succinctly put, China Oriental Group boasts net cash, so it's fair to say it does not have a heavy debt load!

It is just as well that China Oriental Group's load is not too heavy, because its EBIT was down 43% over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if China Oriental Group can strengthen its balance sheet over time. 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. While China Oriental Group has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. During the last three years, China Oriental Group produced sturdy free cash flow equating to 69% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Summing up

While it is always sensible to investigate a company's debt, in this case China Oriental Group has CN¥7.55b in net cash and a decent-looking balance sheet. And it impressed us with free cash flow of CN¥4.5b, being 69% of its EBIT. So we don't have any problem with China Oriental Group's use of debt. 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. Like risks, for instance. Every company has them, and we've spotted 5 warning signs for China Oriental Group (of which 1 is potentially serious!) you should know about.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.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.

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.

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