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. Importantly, Chow Tai Fook Jewellery Group Limited (HKG:1929) does carry debt. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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.
What Is Chow Tai Fook Jewellery Group's Debt?
As you can see below, Chow Tai Fook Jewellery Group had HK$12.1b of debt at March 2021, down from HK$22.7b a year prior. However, it does have HK$6.29b in cash offsetting this, leading to net debt of about HK$5.85b.
How Strong Is Chow Tai Fook Jewellery Group's Balance Sheet?
According to the last reported balance sheet, Chow Tai Fook Jewellery Group had liabilities of HK$29.1b due within 12 months, and liabilities of HK$3.60b due beyond 12 months. On the other hand, it had cash of HK$6.29b and HK$5.73b worth of receivables due within a year. So it has liabilities totalling HK$20.7b more than its cash and near-term receivables, combined.
Of course, Chow Tai Fook Jewellery Group has a titanic market capitalization of HK$154.8b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its 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).
Chow Tai Fook Jewellery Group's net debt is only 0.63 times its EBITDA. And its EBIT covers its interest expense a whopping 34.8 times over. So we're pretty relaxed about its super-conservative use of debt. In addition to that, we're happy to report that Chow Tai Fook Jewellery Group has boosted its EBIT by 82%, thus reducing the spectre of future debt repayments. 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual 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.
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. And the good news does not stop there, as its conversion of EBIT to free cash flow also supports that impression! Overall, we don't think Chow Tai Fook Jewellery Group is taking any bad risks, as its debt load seems modest. So the balance sheet looks pretty healthy, to us. 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. For example, we've discovered 1 warning sign for Chow Tai Fook Jewellery Group that you should be aware of before investing here.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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.
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