Here's Why Tse Sui Luen Jewellery (International) (HKG:417) Has A Meaningful Debt Burden

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Tse Sui Luen Jewellery (International) Limited (HKG:417) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Tse Sui Luen Jewellery (International)

What Is Tse Sui Luen Jewellery (International)'s Debt?

As you can see below, Tse Sui Luen Jewellery (International) had HK$920.4m of debt at March 2022, down from HK$989.1m a year prior. However, it does have HK$354.5m in cash offsetting this, leading to net debt of about HK$565.9m.

A Look At Tse Sui Luen Jewellery (International)'s Liabilities

We can see from the most recent balance sheet that Tse Sui Luen Jewellery (International) had liabilities of HK$1.57b falling due within a year, and liabilities of HK$88.0m due beyond that. On the other hand, it had cash of HK$354.5m and HK$116.7m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$1.19b.

The deficiency here weighs heavily on the HK$284.1m 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. After all, Tse Sui Luen Jewellery (International) would likely require a major re-capitalisation if it had to pay its creditors today.

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.

With a net debt to EBITDA ratio of 5.0, it's fair to say Tse Sui Luen Jewellery (International) does have a significant amount of debt. However, its interest coverage of 3.6 is reasonably strong, which is a good sign. One redeeming factor for Tse Sui Luen Jewellery (International) is that it turned last year's EBIT loss into a gain of HK$75m, over the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But it is Tse Sui Luen Jewellery (International)'s earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Happily for any shareholders, Tse Sui Luen Jewellery (International) actually produced more free cash flow than EBIT over the last year. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

To be frank both Tse Sui Luen Jewellery (International)'s net debt to EBITDA and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Looking at the bigger picture, it seems clear to us that Tse Sui Luen Jewellery (International)'s use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. 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. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for Tse Sui Luen Jewellery (International) you should know about.

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.