Stock Analysis

We Think Chia Tai Enterprises International (HKG:3839) Is Taking Some Risk With Its Debt

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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.' 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. As with many other companies Chia Tai Enterprises International Limited (HKG:3839) makes use of debt. But should shareholders be worried about its use of debt?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Chia Tai Enterprises International

What Is Chia Tai Enterprises International's Debt?

The image below, which you can click on for greater detail, shows that Chia Tai Enterprises International had debt of US$12.9m at the end of September 2020, a reduction from US$13.8m over a year. However, its balance sheet shows it holds US$29.5m in cash, so it actually has US$16.6m net cash.

SEHK:3839 Debt to Equity History January 25th 2021

How Healthy Is Chia Tai Enterprises International's Balance Sheet?

We can see from the most recent balance sheet that Chia Tai Enterprises International had liabilities of US$33.6m falling due within a year, and liabilities of US$36.1m due beyond that. Offsetting these obligations, it had cash of US$29.5m as well as receivables valued at US$18.4m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$21.8m.

While this might seem like a lot, it is not so bad since Chia Tai Enterprises International has a market capitalization of US$43.5m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. Despite its noteworthy liabilities, Chia Tai Enterprises International boasts net cash, so it's fair to say it does not have a heavy debt load!

It is just as well that Chia Tai Enterprises International's load is not too heavy, because its EBIT was down 76% over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Chia Tai Enterprises International will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Chia Tai Enterprises International may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last three years, Chia Tai Enterprises International saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Summing up

While Chia Tai Enterprises International does have more liabilities than liquid assets, it also has net cash of US$16.6m. Despite the cash, we do find Chia Tai Enterprises International's EBIT growth rate concerning, so we're not particularly comfortable with the stock. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Chia Tai Enterprises International is showing 1 warning sign in our investment analysis , you should know about...

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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