Stock Analysis

These 4 Measures Indicate That Texhong Textile Group (HKG:2678) Is Using Debt Extensively

SEHK:2678
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David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. We can see that Texhong Textile Group Limited (HKG:2678) does use debt in its business. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. If things get really bad, the lenders can take control of the business. 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. 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 step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Texhong Textile Group

How Much Debt Does Texhong Textile Group Carry?

The image below, which you can click on for greater detail, shows that Texhong Textile Group had debt of CN¥7.06b at the end of December 2020, a reduction from CN¥8.28b over a year. On the flip side, it has CN¥2.68b in cash leading to net debt of about CN¥4.38b.

debt-equity-history-analysis
SEHK:2678 Debt to Equity History May 17th 2021

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¥8.01b due within 12 months and liabilities of CN¥3.67b due beyond that. On the other hand, it had cash of CN¥2.68b and CN¥1.97b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥7.03b.

This deficit is considerable relative to its market capitalization of CN¥8.56b, so it does suggest shareholders should keep an eye on Texhong Textile Group's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Texhong Textile Group's debt is 2.5 times its EBITDA, and its EBIT cover its interest expense 2.5 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Importantly, Texhong Textile Group's EBIT fell a jaw-dropping 43% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. When analysing debt levels, the balance sheet is the obvious place to start. 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 want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Texhong Textile Group produced sturdy free cash flow equating to 58% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Mulling over Texhong Textile Group's attempt at (not) growing its EBIT, we're certainly not enthusiastic. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Looking at the bigger picture, it seems clear to us that Texhong Textile Group'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. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. To that end, you should learn about the 3 warning signs we've spotted with Texhong Textile Group (including 1 which shouldn't be ignored) .

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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