Chow Tai Fook Jewellery Group (HKG:1929) Seems To Use Debt Quite Sensibly

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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 note that Chow Tai Fook Jewellery Group Limited (HKG:1929) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Chow Tai Fook Jewellery Group

How Much Debt Does Chow Tai Fook Jewellery Group Carry?

You can click the graphic below for the historical numbers, but it shows that as of September 2022 Chow Tai Fook Jewellery Group had HK$28.5b of debt, an increase on HK$21.3b, over one year. However, it does have HK$12.1b in cash offsetting this, leading to net debt of about HK$16.3b.

How Strong Is Chow Tai Fook Jewellery Group's Balance Sheet?

The latest balance sheet data shows that Chow Tai Fook Jewellery Group had liabilities of HK$54.3b due within a year, and liabilities of HK$4.16b falling due after that. Offsetting these obligations, it had cash of HK$12.1b as well as receivables valued at HK$7.03b due within 12 months. So it has liabilities totalling HK$39.3b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Chow Tai Fook Jewellery Group has a huge market capitalization of HK$137.2b, 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 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Chow Tai Fook Jewellery Group's net debt to EBITDA ratio of about 1.7 suggests only moderate use of debt. And its strong interest cover of 41.7 times, makes us even more comfortable. Unfortunately, Chow Tai Fook Jewellery Group's EBIT flopped 14% over the last four quarters. If that sort of decline is not arrested, then the managing its debt will be harder than selling broccoli flavoured ice-cream for a premium. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Chow Tai Fook Jewellery Group can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

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, Chow Tai Fook Jewellery Group actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

Chow Tai Fook Jewellery Group's interest cover was a real positive on this analysis, as was its conversion of EBIT to free cash flow. But truth be told its EBIT growth rate had us nibbling our nails. When we consider all the elements mentioned above, it seems to us that Chow Tai Fook Jewellery Group is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Chow Tai Fook Jewellery Group 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.