Is Tian Chang Group Holdings (HKG:2182) A Risky Investment?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Tian Chang Group Holdings Ltd. (HKG:2182) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, 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.

Check out our latest analysis for Tian Chang Group Holdings

How Much Debt Does Tian Chang Group Holdings Carry?

As you can see below, Tian Chang Group Holdings had HK$205.8m of debt at June 2022, down from HK$249.5m a year prior. However, because it has a cash reserve of HK$93.5m, its net debt is less, at about HK$112.3m.

How Strong Is Tian Chang Group Holdings' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Tian Chang Group Holdings had liabilities of HK$404.4m due within 12 months and liabilities of HK$32.8m due beyond that. Offsetting these obligations, it had cash of HK$93.5m as well as receivables valued at HK$210.6m due within 12 months. So its liabilities total HK$133.1m more than the combination of its cash and short-term receivables.

Tian Chang Group Holdings has a market capitalization of HK$232.5m, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).

Tian Chang Group Holdings's net debt is only 0.67 times its EBITDA. And its EBIT easily covers its interest expense, being 22.0 times the size. So we're pretty relaxed about its super-conservative use of debt. Fortunately, Tian Chang Group Holdings grew its EBIT by 5.3% in the last year, making that debt load look even more manageable. There's no doubt that we learn most about debt from the balance sheet. But it is Tian Chang Group Holdings'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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Tian Chang Group Holdings reported free cash flow worth 10.0% 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

When it comes to the balance sheet, the standout positive for Tian Chang Group Holdings was the fact that it seems able to cover its interest expense with its EBIT confidently. But the other factors we noted above weren't so encouraging. For example, its conversion of EBIT to free cash flow makes us a little nervous about its debt. When we consider all the factors mentioned above, we do feel a bit cautious about Tian Chang Group Holdings's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Be aware that Tian Chang Group Holdings 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.