Is Tongguan Gold Group (HKG:340) A Risky Investment?

Simply Wall St
August 30, 2021
Source: Shutterstock

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that '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. Importantly, Tongguan Gold Group Limited (HKG:340) does carry debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Tongguan Gold Group

What Is Tongguan Gold Group's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Tongguan Gold Group had HK$180.5m of debt in June 2021, down from HK$209.9m, one year before. However, it also had HK$114.2m in cash, and so its net debt is HK$66.3m.

SEHK:340 Debt to Equity History August 30th 2021

How Healthy Is Tongguan Gold Group's Balance Sheet?

According to the last reported balance sheet, Tongguan Gold Group had liabilities of HK$676.5m due within 12 months, and liabilities of HK$1.04b due beyond 12 months. Offsetting these obligations, it had cash of HK$114.2m as well as receivables valued at HK$12.2m due within 12 months. So it has liabilities totalling HK$1.59b more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of HK$2.51b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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).

Tongguan Gold Group's net debt is only 0.46 times its EBITDA. And its EBIT covers its interest expense a whopping 52.3 times over. So we're pretty relaxed about its super-conservative use of debt. It was also good to see that despite losing money on the EBIT line last year, Tongguan Gold Group turned things around in the last 12 months, delivering and EBIT of HK$78m. When analysing debt levels, the balance sheet is the obvious place to start. But it is Tongguan Gold Group'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 company can only pay off debt with cold hard cash, not accounting profits. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Tongguan Gold Group recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

While Tongguan Gold Group's conversion of EBIT to free cash flow has us nervous. For example, its interest cover and net debt to EBITDA give us some confidence in its ability to manage its debt. We think that Tongguan Gold 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. To that end, you should be aware of the 1 warning sign we've spotted with Tongguan Gold Group .

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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