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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 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. Importantly, Ouhua Energy Holdings Limited (SGX:AJ2) does carry debt. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.
Check out our latest analysis for Ouhua Energy Holdings
What Is Ouhua Energy Holdings's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 Ouhua Energy Holdings had CN¥250.3m of debt, an increase on CN¥182.9m, over one year. However, it also had CN¥50.6m in cash, and so its net debt is CN¥199.7m.
A Look At Ouhua Energy Holdings's Liabilities
Zooming in on the latest balance sheet data, we can see that Ouhua Energy Holdings had liabilities of CN¥333.5m due within 12 months and liabilities of CN¥22.4m due beyond that. Offsetting this, it had CN¥50.6m in cash and CN¥244.5m in receivables that were due within 12 months. So it has liabilities totalling CN¥60.7m more than its cash and near-term receivables, combined.
This deficit casts a shadow over the CN¥23.9m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, Ouhua Energy Holdings would probably need a major re-capitalization if its creditors were to demand repayment.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).