Tongfu MicroelectronicsLtd (SZSE:002156) Takes On Some Risk With Its Use Of Debt

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.' 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 Tongfu Microelectronics Co.,Ltd (SZSE:002156) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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 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, 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. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Tongfu MicroelectronicsLtd

How Much Debt Does Tongfu MicroelectronicsLtd Carry?

The chart below, which you can click on for greater detail, shows that Tongfu MicroelectronicsLtd had CN¥14.8b in debt in September 2024; about the same as the year before. However, it also had CN¥5.19b in cash, and so its net debt is CN¥9.61b.

How Strong Is Tongfu MicroelectronicsLtd's Balance Sheet?

The latest balance sheet data shows that Tongfu MicroelectronicsLtd had liabilities of CN¥13.9b due within a year, and liabilities of CN¥8.72b falling due after that. On the other hand, it had cash of CN¥5.19b and CN¥5.05b worth of receivables due within a year. So it has liabilities totalling CN¥12.4b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Tongfu MicroelectronicsLtd has a market capitalization of CN¥48.0b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Tongfu MicroelectronicsLtd's net debt is sitting at a very reasonable 1.8 times its EBITDA, while its EBIT covered its interest expense just 3.1 times last year. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. Pleasingly, Tongfu MicroelectronicsLtd is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 163% gain in the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Tongfu MicroelectronicsLtd'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Tongfu MicroelectronicsLtd saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

Tongfu MicroelectronicsLtd's conversion of EBIT to free cash flow and interest cover definitely weigh on it, in our esteem. But the good news is it seems to be able to grow its EBIT with ease. We think that Tongfu MicroelectronicsLtd's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. 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. For example - Tongfu MicroelectronicsLtd has 1 warning sign we think you should be aware of.

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.

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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.