Tongguan Gold Group (HKG:340) Takes On Some Risk With Its Use Of Debt

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.' 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. Importantly, Tongguan Gold Group Limited (HKG:340) does carry debt. But the more important question is: how much risk is that debt creating?

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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Tongguan Gold Group

How Much Debt Does Tongguan Gold Group Carry?

As you can see below, at the end of December 2020, Tongguan Gold Group had HK$304.0m of debt, up from HK$161.3m a year ago. Click the image for more detail. However, it also had HK$160.3m in cash, and so its net debt is HK$143.7m.

A Look At Tongguan Gold Group's Liabilities

According to the last reported balance sheet, Tongguan Gold Group had liabilities of HK$790.6m due within 12 months, and liabilities of HK$1.04b due beyond 12 months. On the other hand, it had cash of HK$160.3m and HK$14.7m worth of receivables due within a year. So it has liabilities totalling HK$1.65b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the HK$1.09b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Tongguan Gold Group would likely require a major re-capitalisation if it had to pay its creditors today.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Tongguan Gold Group's net debt to EBITDA ratio of about 2.4 suggests only moderate use of debt. And its strong interest cover of 1k times, makes us even more comfortable. Notably, Tongguan Gold Group made a loss at the EBIT level, last year, but improved that to positive EBIT of HK$5.8m in the last twelve months. 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 Tongguan Gold Group 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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, Tongguan Gold Group saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both Tongguan Gold Group's level of total liabilities and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Overall, it seems to us that Tongguan Gold Group's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. Even though Tongguan Gold Group lost money on the bottom line, its positive EBIT suggests the business itself has potential. So you might want to check out how earnings have been trending over the last few years.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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This article by Simply Wall St is general in nature. 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.
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