The external fund manager backed by Berkshire Hathaway’s Charlie Munger, Li Lu, makes no bones about it when he says ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital. 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. Importantly, Chow Tai Fook Jewellery Group Limited (HKG:1929) does carry debt. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Chow Tai Fook Jewellery Group’s Debt?
You can click the graphic below for the historical numbers, but it shows that as of September 2019 Chow Tai Fook Jewellery Group had HK$21.5b of debt, an increase on HK$16.8b, over one year. However, it does have HK$5.60b in cash offsetting this, leading to net debt of about HK$15.9b.
How Strong Is Chow Tai Fook Jewellery Group’s Balance Sheet?
The latest balance sheet data shows that Chow Tai Fook Jewellery Group had liabilities of HK$34.7b due within a year, and liabilities of HK$2.60b falling due after that. On the other hand, it had cash of HK$5.60b and HK$5.43b worth of receivables due within a year. So it has liabilities totalling HK$26.3b more than its cash and near-term receivables, combined.
This deficit isn’t so bad because Chow Tai Fook Jewellery Group is worth HK$73.9b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
We measure a company’s debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Chow Tai Fook Jewellery Group’s net debt to EBITDA ratio of about 2.3 suggests only moderate use of debt. And its strong interest cover of 17.0 times, makes us even more comfortable. Sadly, Chow Tai Fook Jewellery Group’s EBIT actually dropped 4.4% in the last year. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. There’s no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Chow Tai Fook Jewellery Group’s ability to maintain a healthy balance sheet going forward. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So we always check how much of that EBIT is translated into free cash flow. Happily for any shareholders, Chow Tai Fook Jewellery Group actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
Happily, Chow Tai Fook Jewellery Group’s impressive interest cover implies it has the upper hand on its debt. But, on a more sombre note, we are a little concerned by its EBIT growth rate. All these things considered, it appears that Chow Tai Fook Jewellery Group can comfortably handle its current debt levels. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it’s worth monitoring the balance sheet. There’s no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should be aware of the 2 warning signs we’ve spotted with Chow Tai Fook Jewellery Group .
If, after all that, you’re more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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.
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