These 4 Measures Indicate That Tongfang Kontafarma Holdings (HKG:1312) Is Using Debt Extensively

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Tongfang Kontafarma Holdings Limited (HKG:1312) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Tongfang Kontafarma Holdings

What Is Tongfang Kontafarma Holdings's Debt?

As you can see below, at the end of June 2020, Tongfang Kontafarma Holdings had HK$578.0m of debt, up from HK$518.4m a year ago. Click the image for more detail. However, it also had HK$393.9m in cash, and so its net debt is HK$184.1m.

How Strong Is Tongfang Kontafarma Holdings's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Tongfang Kontafarma Holdings had liabilities of HK$1.80b due within 12 months and liabilities of HK$556.8m due beyond that. On the other hand, it had cash of HK$393.9m and HK$1.65b worth of receivables due within a year. So it has liabilities totalling HK$313.5m more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of HK$491.8m. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Tongfang Kontafarma Holdings has a very low debt to EBITDA ratio of 0.68 so it is strange to see weak interest coverage, with last year's EBIT being only 1.3 times the interest expense. So while we're not necessarily alarmed we think that its debt is far from trivial. Also relevant is that Tongfang Kontafarma Holdings has grown its EBIT by a very respectable 20% in the last year, thus enhancing its ability to pay down debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is Tongfang Kontafarma Holdings'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 we always check how much of that EBIT is translated into free cash flow. Over the last three years, Tongfang Kontafarma Holdings reported free cash flow worth 11% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

Tongfang Kontafarma Holdings's struggle to cover its interest expense with its EBIT had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. For example its EBIT growth rate was refreshing. When we consider all the factors discussed, it seems to us that Tongfang Kontafarma Holdings is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. 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. Consider for instance, the ever-present spectre of investment risk. We've identified 3 warning signs with Tongfang Kontafarma Holdings , and understanding them should be part of your investment process.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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