Tianjin Tianbao Energy (HKG:1671) Takes On Some Risk With Its Use Of Debt

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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that Tianjin Tianbao Energy Co., Ltd. (HKG:1671) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Tianjin Tianbao Energy

What Is Tianjin Tianbao Energy's Debt?

As you can see below, at the end of June 2020, Tianjin Tianbao Energy had CN¥158.6m of debt, up from none a year ago. Click the image for more detail. However, it does have CN¥116.3m in cash offsetting this, leading to net debt of about CN¥42.3m.

How Strong Is Tianjin Tianbao Energy's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Tianjin Tianbao Energy had liabilities of CN¥243.5m due within 12 months and liabilities of CN¥160.6m due beyond that. Offsetting these obligations, it had cash of CN¥116.3m as well as receivables valued at CN¥49.6m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥238.2m.

The deficiency here weighs heavily on the CN¥87.7m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. After all, Tianjin Tianbao Energy would likely require a major re-capitalisation if it had to pay its creditors today.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

While Tianjin Tianbao Energy's low debt to EBITDA ratio of 0.79 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 3.6 times last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Tianjin Tianbao Energy grew its EBIT by 2.8% in the last year. Whilst that hardly knocks our socks off it is a positive when it comes to debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Tianjin Tianbao Energy's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

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, Tianjin Tianbao Energy recorded free cash flow worth a fulsome 87% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Our View

Neither Tianjin Tianbao Energy's ability to handle its total liabilities nor its interest cover gave us confidence in its ability to take on more debt. But the good news is it seems to be able to convert EBIT to free cash flow with ease. It's also worth noting that Tianjin Tianbao Energy is in the Electric Utilities industry, which is often considered to be quite defensive. Taking the abovementioned factors together we do think Tianjin Tianbao Energy's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Take risks, for example - Tianjin Tianbao Energy has 4 warning signs (and 1 which doesn't sit too well with us) we think you should know about.

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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