Is Texhong Textile Group (HKG:2678) A Risky Investment?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Texhong Textile Group Limited (HKG:2678) does carry debt. But the more important question is: how much risk is that debt creating?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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.

Our analysis indicates that 2678 is potentially undervalued!

What Is Texhong Textile Group's Net Debt?

The image below, which you can click on for greater detail, shows that at June 2022 Texhong Textile Group had debt of CN¥8.15b, up from CN¥6.20b in one year. On the flip side, it has CN¥2.40b in cash leading to net debt of about CN¥5.75b.

How Strong Is Texhong Textile Group's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Texhong Textile Group had liabilities of CN¥10.9b due within 12 months and liabilities of CN¥4.22b due beyond that. On the other hand, it had cash of CN¥2.40b and CN¥3.45b worth of receivables due within a year. So its liabilities total CN¥9.29b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the CN¥4.50b 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. At the end of the day, Texhong Textile Group would probably need a major re-capitalization if its creditors were to demand repayment.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Texhong Textile Group's net debt is only 1.4 times its EBITDA. And its EBIT easily covers its interest expense, being 22.0 times the size. So we're pretty relaxed about its super-conservative use of debt. In addition to that, we're happy to report that Texhong Textile Group has boosted its EBIT by 43%, thus reducing the spectre of future debt repayments. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Texhong Textile 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent three years, Texhong Textile Group recorded free cash flow of 35% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

We feel some trepidation about Texhong Textile Group's difficulty level of total liabilities, but we've got positives to focus on, too. For example, its interest cover and EBIT growth rate give us some confidence in its ability to manage its debt. When we consider all the factors discussed, it seems to us that Texhong Textile Group is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. For example, we've discovered 3 warning signs for Texhong Textile Group (2 make us uncomfortable!) that you should be aware of before investing here.

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.