Does Tomson Group (HKG:258) Have A Healthy Balance Sheet?

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.' 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 Tomson Group Limited (HKG:258) does use debt in its business. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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.

View our latest analysis for Tomson Group

What Is Tomson Group's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Tomson Group had HK$1.01b of debt in June 2020, down from HK$1.31b, one year before. But it also has HK$3.37b in cash to offset that, meaning it has HK$2.37b net cash.

How Healthy Is Tomson Group's Balance Sheet?

According to the last reported balance sheet, Tomson Group had liabilities of HK$5.02b due within 12 months, and liabilities of HK$1.54b due beyond 12 months. Offsetting these obligations, it had cash of HK$3.37b as well as receivables valued at HK$211.3m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$2.97b.

This deficit is considerable relative to its market capitalization of HK$3.33b, so it does suggest shareholders should keep an eye on Tomson Group's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution. While it does have liabilities worth noting, Tomson Group also has more cash than debt, so we're pretty confident it can manage its debt safely.

But the other side of the story is that Tomson Group saw its EBIT decline by 2.8% over the last year. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Tomson 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Tomson Group may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. In the last three years, Tomson Group created free cash flow amounting to 6.7% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Summing up

Although Tomson Group's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of HK$2.37b. So while Tomson Group does not have a great balance sheet, it's certainly not too bad. 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. For example, we've discovered 3 warning signs for Tomson Group (1 is a bit unpleasant!) that you should be aware of before investing here.

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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