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 Tsaker Chemical Group Limited (HKG:1986) does use debt in its business. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
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. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Tsaker Chemical Group's Net Debt?
As you can see below, Tsaker Chemical Group had CN¥290.5m of debt, at June 2020, which is about the same as the year before. You can click the chart for greater detail. However, it does have CN¥120.0m in cash offsetting this, leading to net debt of about CN¥170.5m.
How Healthy Is Tsaker Chemical Group's Balance Sheet?
According to the last reported balance sheet, Tsaker Chemical Group had liabilities of CN¥648.6m due within 12 months, and liabilities of CN¥49.2m due beyond 12 months. Offsetting these obligations, it had cash of CN¥120.0m as well as receivables valued at CN¥211.9m due within 12 months. So it has liabilities totalling CN¥365.9m more than its cash and near-term receivables, combined.
While this might seem like a lot, it is not so bad since Tsaker Chemical Group has a market capitalization of CN¥1.25b, 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.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Tsaker Chemical Group's net debt is only 0.33 times its EBITDA. And its EBIT easily covers its interest expense, being 21.8 times the size. So we're pretty relaxed about its super-conservative use of debt. It is just as well that Tsaker Chemical Group's load is not too heavy, because its EBIT was down 41% over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. 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 Tsaker Chemical Group will need earnings to service that debt. 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, Tsaker Chemical Group recorded free cash flow of 21% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
While Tsaker Chemical Group's EBIT growth rate has us nervous. To wit both its interest cover and net debt to EBITDA were encouraging signs. We think that Tsaker Chemical Group's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Consider risks, for instance. Every company has them, and we've spotted 2 warning signs for Tsaker Chemical Group you should know about.
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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