Genes Tech Group Holdings (HKG:8257) Has A Somewhat Strained Balance Sheet

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 note that Genes Tech Group Holdings Company Limited (HKG:8257) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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.

See our latest analysis for Genes Tech Group Holdings

How Much Debt Does Genes Tech Group Holdings Carry?

As you can see below, Genes Tech Group Holdings had NT$739.1m of debt at December 2020, down from NT$778.9m a year prior. However, because it has a cash reserve of NT$96.2m, its net debt is less, at about NT$642.9m.

How Strong Is Genes Tech Group Holdings' Balance Sheet?

We can see from the most recent balance sheet that Genes Tech Group Holdings had liabilities of NT$1.39b falling due within a year, and liabilities of NT$299.6m due beyond that. Offsetting these obligations, it had cash of NT$96.2m as well as receivables valued at NT$303.9m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$1.29b.

Given this deficit is actually higher than the company's market capitalization of NT$1.15b, we think shareholders really should watch Genes Tech Group Holdings's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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).

Genes Tech Group Holdings's net debt is 3.0 times its EBITDA, which is a significant but still reasonable amount of leverage. However, its interest coverage of 13.8 is very high, suggesting that the interest expense on the debt is currently quite low. Shareholders should be aware that Genes Tech Group Holdings's EBIT was down 34% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Genes Tech Group Holdings will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Genes Tech Group Holdings created free cash flow amounting to 5.2% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

Mulling over Genes Tech Group Holdings's attempt at (not) growing its EBIT, we're certainly not enthusiastic. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. We're quite clear that we consider Genes Tech Group Holdings to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. We've identified 2 warning signs with Genes Tech Group Holdings (at least 1 which shouldn't be ignored) , and understanding them should be part of your investment process.

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. 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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