Does Chow Tai Fook Jewellery Group (HKG:1929) Have A Healthy Balance Sheet?

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. We can see that Chow Tai Fook Jewellery Group Limited (HKG:1929) does use debt in its business. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Chow Tai Fook Jewellery Group

What Is Chow Tai Fook Jewellery Group's Debt?

The image below, which you can click on for greater detail, shows that Chow Tai Fook Jewellery Group had debt of HK$26.4b at the end of September 2023, a reduction from HK$28.5b over a year. However, because it has a cash reserve of HK$5.94b, its net debt is less, at about HK$20.5b.

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

We can see from the most recent balance sheet that Chow Tai Fook Jewellery Group had liabilities of HK$54.5b falling due within a year, and liabilities of HK$3.36b due beyond that. Offsetting these obligations, it had cash of HK$5.94b as well as receivables valued at HK$6.40b due within 12 months. So its liabilities total HK$45.5b more than the combination of its cash and short-term receivables.

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$109.3b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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). 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).

Chow Tai Fook Jewellery Group's net debt to EBITDA ratio of about 2.0 suggests only moderate use of debt. And its commanding EBIT of 23.0 times its interest expense, implies the debt load is as light as a peacock feather. If Chow Tai Fook Jewellery Group can keep growing EBIT at last year's rate of 11% over the last year, then it will find its debt load easier to manage. 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're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Happily for any shareholders, Chow Tai Fook Jewellery Group actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

The good news is that Chow Tai Fook Jewellery Group's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And the good news does not stop there, as its conversion of EBIT to free cash flow also supports that impression! When we consider the range of factors above, it looks like Chow Tai Fook Jewellery Group is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Be aware that Chow Tai Fook Jewellery Group is showing 2 warning signs in our investment analysis , you should know about...

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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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.