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

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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 examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Chow Tai Fook Jewellery Group

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

As you can see below, at the end of March 2022, Chow Tai Fook Jewellery Group had HK$24.8b of debt, up from HK$12.1b a year ago. Click the image for more detail. However, because it has a cash reserve of HK$15.2b, its net debt is less, at about HK$9.58b.

How Strong 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$49.6b falling due within a year, and liabilities of HK$3.55b due beyond that. Offsetting this, it had HK$15.2b in cash and HK$5.44b in receivables that were due within 12 months. So its liabilities total HK$32.5b more than the combination of its cash and short-term receivables.

Chow Tai Fook Jewellery Group has a very large market capitalization of HK$147.6b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). 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 has a low net debt to EBITDA ratio of only 1.0. And its EBIT easily covers its interest expense, being 38.8 times the size. So we're pretty relaxed about its super-conservative use of debt. Chow Tai Fook Jewellery Group's EBIT was pretty flat over the last year, but that shouldn't be an issue given the it doesn't have a lot of debt. There's no doubt that we learn most about debt from the balance sheet. 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. 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 conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

Happily, Chow Tai Fook Jewellery Group's impressive interest cover implies it has the upper hand on its debt. And the good news does not stop there, as its conversion of EBIT to free cash flow also supports that impression! Taking all this data into account, it seems to us that Chow Tai Fook Jewellery Group takes a pretty sensible approach to debt. While that brings some risk, it can also enhance returns for shareholders. 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 - Chow Tai Fook Jewellery Group has 1 warning sign we think you should be aware of.

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.

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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.