We Think Tiande Chemical Holdings (HKG:609) Can Stay On Top Of Its Debt

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Tiande Chemical Holdings Limited (HKG:609) does use debt in its business. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. 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, 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 think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Tiande Chemical Holdings

What Is Tiande Chemical Holdings's Net Debt?

As you can see below, at the end of June 2020, Tiande Chemical Holdings had CN¥205.8m of debt, up from CN¥109.2m a year ago. Click the image for more detail. However, it also had CN¥103.4m in cash, and so its net debt is CN¥102.4m.

How Strong Is Tiande Chemical Holdings's Balance Sheet?

According to the last reported balance sheet, Tiande Chemical Holdings had liabilities of CN¥528.3m due within 12 months, and liabilities of CN¥26.3m due beyond 12 months. On the other hand, it had cash of CN¥103.4m and CN¥336.6m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥114.5m.

While this might seem like a lot, it is not so bad since Tiande Chemical Holdings has a market capitalization of CN¥490.5m, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

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).

With net debt sitting at just 0.56 times EBITDA, Tiande Chemical Holdings is arguably pretty conservatively geared. And this view is supported by the solid interest coverage, with EBIT coming in at 8.9 times the interest expense over the last year. Even more impressive was the fact that Tiande Chemical Holdings grew its EBIT by 646% over twelve months. That boost will make it even easier to pay down debt going forward. 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 Tiande Chemical Holdings 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Tiande Chemical Holdings 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

Based on what we've seen Tiande Chemical Holdings is not finding it easy, given its conversion of EBIT to free cash flow, but the other factors we considered give us cause to be optimistic. In particular, we are dazzled with its EBIT growth rate. When we consider all the elements mentioned above, it seems to us that Tiande Chemical Holdings is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Like risks, for instance. Every company has them, and we've spotted 2 warning signs for Tiande Chemical Holdings (of which 1 doesn't sit too well with us!) you should know about.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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