Is Texhong Textile Group (HKG:2678) Using Too Much Debt?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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, Texhong Textile Group Limited (HKG:2678) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Texhong Textile Group

What Is Texhong Textile Group's Debt?

The image below, which you can click on for greater detail, shows that at June 2020 Texhong Textile Group had debt of CN¥10.0b, up from CN¥7.82b in one year. However, because it has a cash reserve of CN¥4.09b, its net debt is less, at about CN¥5.95b.

How Strong Is Texhong Textile Group's Balance Sheet?

The latest balance sheet data shows that Texhong Textile Group had liabilities of CN¥9.85b due within a year, and liabilities of CN¥5.22b falling due after that. Offsetting this, it had CN¥4.09b in cash and CN¥1.59b in receivables that were due within 12 months. So it has liabilities totalling CN¥9.39b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the CN¥5.04b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. 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 has a debt to EBITDA ratio of 2.9 and its EBIT covered its interest expense 2.7 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Even worse, Texhong Textile Group saw its EBIT tank 32% over the last 12 months. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. 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 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Texhong Textile Group recorded free cash flow of 31% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

On the face of it, Texhong Textile Group's EBIT growth rate left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. And even its net debt to EBITDA fails to inspire much confidence. After considering the datapoints discussed, we think Texhong Textile Group has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. 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. Be aware that Texhong Textile Group is showing 2 warning signs in our investment analysis , and 1 of those can't be ignored...

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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. 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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