These 4 Measures Indicate That Tongkun Group (SHSE:601233) Is Using Debt In A Risky Way

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. As with many other companies Tongkun Group Co., Ltd. (SHSE:601233) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Tongkun Group

What Is Tongkun Group's Net Debt?

As you can see below, at the end of March 2024, Tongkun Group had CN¥61.7b of debt, up from CN¥46.6b a year ago. Click the image for more detail. However, it also had CN¥15.4b in cash, and so its net debt is CN¥46.3b.

A Look At Tongkun Group's Liabilities

The latest balance sheet data shows that Tongkun Group had liabilities of CN¥53.3b due within a year, and liabilities of CN¥22.5b falling due after that. On the other hand, it had cash of CN¥15.4b and CN¥1.95b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥58.4b.

The deficiency here weighs heavily on the CN¥32.4b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. After all, Tongkun Group would likely require a major re-capitalisation if it had to pay its creditors today.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

With a net debt to EBITDA ratio of 8.9, it's fair to say Tongkun Group does have a significant amount of debt. But the good news is that it boasts fairly comforting interest cover of 4.3 times, suggesting it can responsibly service its obligations. One redeeming factor for Tongkun Group is that it turned last year's EBIT loss into a gain of CN¥1.3b, over the last twelve months. 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 Tongkun 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 it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. During the last year, Tongkun Group burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both Tongkun Group's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least its EBIT growth rate is not so bad. Taking into account all the aforementioned factors, it looks like Tongkun Group has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 2 warning signs with Tongkun Group (at least 1 which is potentially serious) , and understanding them should be part of your investment process.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.

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