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.' 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. We note that Chia Tai Enterprises International Limited (HKG:3839) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Chia Tai Enterprises International's Debt?
As you can see below, at the end of September 2021, Chia Tai Enterprises International had US$44.9m of debt, up from US$12.9m a year ago. Click the image for more detail. However, it also had US$26.2m in cash, and so its net debt is US$18.7m.
How Strong Is Chia Tai Enterprises International's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Chia Tai Enterprises International had liabilities of US$58.2m due within 12 months and liabilities of US$22.0m due beyond that. On the other hand, it had cash of US$26.2m and US$33.8m worth of receivables due within a year. So its liabilities total US$20.2m more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since Chia Tai Enterprises International has a market capitalization of US$47.0m, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). 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).
Chia Tai Enterprises International's net debt to EBITDA ratio of about 2.4 suggests only moderate use of debt. And its strong interest cover of 26.6 times, makes us even more comfortable. Notably, Chia Tai Enterprises International's EBIT launched higher than Elon Musk, gaining a whopping 137% on last year. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Chia Tai Enterprises International's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Chia Tai Enterprises International burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
Based on what we've seen Chia Tai Enterprises International is not finding it easy, given its conversion of EBIT to free cash flow, but the other factors we considered give us cause to be optimistic. There's no doubt that its ability to to cover its interest expense with its EBIT is pretty flash. Looking at all this data makes us feel a little cautious about Chia Tai Enterprises International's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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. Be aware that Chia Tai Enterprises International is showing 2 warning signs in our investment analysis , you should know about...
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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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.