Does Ten Pao Group Holdings (HKG:1979) Have A Healthy Balance Sheet?

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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, Ten Pao Group Holdings Limited (HKG:1979) does carry debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Ten Pao Group Holdings

What Is Ten Pao Group Holdings's Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2022 Ten Pao Group Holdings had HK$625.8m of debt, an increase on HK$433.4m, over one year. On the flip side, it has HK$236.4m in cash leading to net debt of about HK$389.5m.

How Strong Is Ten Pao Group Holdings' Balance Sheet?

According to the last reported balance sheet, Ten Pao Group Holdings had liabilities of HK$2.40b due within 12 months, and liabilities of HK$419.8m due beyond 12 months. On the other hand, it had cash of HK$236.4m and HK$1.49b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$1.09b.

This deficit is considerable relative to its market capitalization of HK$1.47b, so it does suggest shareholders should keep an eye on Ten Pao Group Holdings' use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Ten Pao Group Holdings has a low net debt to EBITDA ratio of only 0.74. And its EBIT easily covers its interest expense, being 61.9 times the size. So we're pretty relaxed about its super-conservative use of debt. In fact Ten Pao Group Holdings's saving grace is its low debt levels, because its EBIT has tanked 33% in the last twelve months. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Ten Pao Group Holdings can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

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. Over the last three years, Ten Pao Group Holdings barely recorded positive free cash flow, in total. Some might say that's a concern, when it comes considering how easily it would be for it to down debt.

Our View

We'd go so far as to say Ten Pao Group Holdings's EBIT growth rate was disappointing. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Looking at the bigger picture, it seems clear to us that Ten Pao Group Holdings's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 3 warning signs for Ten Pao Group Holdings you should be aware of, and 1 of them makes us a bit uncomfortable.

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.