By Federal Reserve Standards Kaiwen Education
is a Highly Leveraged and Risky Business
is a Highly Leveraged and Risky Business
Companies like Kaiwen Education, the for-profit selected by Rider University as the future owner of Westminster Choir College, are in the news, not in a good way. On Sunday, May 12 Joseph DiStefano used his column in the business section of The Philadelphia Inquirer to express concern about an initial public offering of stock (IPO) by a pharmaceutical company.
In its prospectus the company warns investors that its accumulated debt is so big that, in DiStefano’s words, “it will have a tough time paying its bills when the economy eventually slows, if it doesn’t quickly turn profitable”.
The company has all the hallmarks of Kaiwen Education, which continues to rely on debt to fund its operations, continues to incur large losses, and warns investors that economic downturns pose a major risk to its business.
DiStefano’s column comes a few days after the May 6 report by the U.S. Federal Reserve which, along with other analyses, cites a disturbing growth in corporate borrowing and heavy debt carried by marginal firms as posing risk to financial systems in the United States and China. The Federal Reserve writes:
Borrowing by businesses is historically high relative to gross domestic product (GDP), with the most rapid increase in debt concentrated among the riskiest firms amid signs of deteriorating credit standards. (p. 7)
In China easier access to credit, mainly enabled by the State reducing required bank reserves, has caused corporate borrowing to rise sharply since 2008 – 60 percentage points. There, corporate debt stands at 160% of China’s GDP, more than double the comparable ratio – 74% - for the U.S., a U.S. historical high. Of great concern as well to many inside and outside of China, including those at the upper echelons of the Chinese government, is the overall level of national debt in China – extraordinarily high at over 250% of GDP. This level of debt constricts the issue of new loans in the future, used in part by companies to service – to pay interest on or pay off – current loans. Kaiwen has taken out new loans for these purposes.
Prominent red flags raised by the Federal Reserve in its current report are (1) the current level of debt carried by highly leveraged firms and (2) the growth in the issuance of new loans to these firms, the latter due to the lessening of credit standards and restrictions placed on borrowers by lenders – such as, prohibiting additional debt and the payment of dividends.
In general, highly leveraged firms carry debt well in excess of earnings, making them very vulnerable to loan default and bankruptcy in the event of an economic downturn.
For the Federal Reserve, firms that are highly leveraged are those with a ratio of company debt to EBITDA (annual earnings before the payment of interest and taxes, and the deduction of depreciation and amortization) above 6. (p. 19) It is desirable to have a ratio of 3 or less. This ratio measures the extent to which a company has extended its financial obligations beyond its earnings, risking that its fate will be in others’ hands. Another indicator of a highly leveraged firm is the doubling of total company financial liabilities (obligations) from one year to another.
Performing these calculations for Kaiwen Education reveals that it is a highly leveraged organization. From 2017 to 2018, Kaiwen’s total liabilities as a company grew 81%, from 934 million Yuan to 1.7 billion Yuan. More significant is the ratio that compares company debt to its annual earnings. At the end of 2018 Kaiwen had short-term debt of 199 million Yuan and long-term debt of 990 million Yuan, or a total reported debt of 1.19 billion Yuan. For 2018, company EBITDA was 10.9 million Yuan. For Kaiwen, then, the ratio of debt-to-EBITDA is a remarkable 109.1 (1.19 billion÷10.9 million), well beyond the Federal Reserve’s figure of 6. First quarter results from this year indicate that Kaiwen has paid off its short-term debt, almost certainly using funds from its long-term loans. However, the calculation of this ratio just using Kaiwen’s remaining long-term debt of 990 million Yuan still yields a number well beyond 6 – 90.8.