Is Chow Tai Fook Jewellery Group (HKG:1929) A Risky Investment?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Chow Tai Fook Jewellery Group Limited (HKG:1929) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Chow Tai Fook Jewellery Group

What Is Chow Tai Fook Jewellery Group's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Chow Tai Fook Jewellery Group had HK$19.9b of debt in September 2020, down from HK$21.5b, one year before. However, because it has a cash reserve of HK$7.61b, its net debt is less, at about HK$12.3b.

A Look At Chow Tai Fook Jewellery Group's Liabilities

According to the last reported balance sheet, Chow Tai Fook Jewellery Group had liabilities of HK$33.6b due within 12 months, and liabilities of HK$4.10b due beyond 12 months. Offsetting this, it had HK$7.61b in cash and HK$5.72b in receivables that were due within 12 months. So it has liabilities totalling HK$24.4b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Chow Tai Fook Jewellery Group is worth a massive HK$101.2b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Chow Tai Fook Jewellery Group's net debt to EBITDA ratio of about 1.9 suggests only moderate use of debt. And its commanding EBIT of 14.5 times its interest expense, implies the debt load is as light as a peacock feather. Unfortunately, Chow Tai Fook Jewellery Group's EBIT flopped 10% 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. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Chow Tai Fook Jewellery Group's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. 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 suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But the stark truth is that we are concerned by its EBIT growth rate. Looking at all the aforementioned factors together, it strikes us that Chow Tai Fook Jewellery Group can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 2 warning signs for Chow Tai Fook Jewellery Group you should be aware of.

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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