Here's Why Tonking New Energy Group Holdings (HKG:8326) Can Manage Its Debt Responsibly

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.' 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 Tonking New Energy Group Holdings Limited (HKG:8326) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. 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 Tonking New Energy Group Holdings

How Much Debt Does Tonking New Energy Group Holdings Carry?

You can click the graphic below for the historical numbers, but it shows that as of March 2022 Tonking New Energy Group Holdings had HK$85.4m of debt, an increase on HK$71.5m, over one year. On the flip side, it has HK$34.6m in cash leading to net debt of about HK$50.8m.

How Strong Is Tonking New Energy Group Holdings' Balance Sheet?

The latest balance sheet data shows that Tonking New Energy Group Holdings had liabilities of HK$169.0m due within a year, and liabilities of HK$2.33m falling due after that. Offsetting these obligations, it had cash of HK$34.6m as well as receivables valued at HK$246.5m due within 12 months. So it actually has HK$109.8m more liquid assets than total liabilities.

This surplus strongly suggests that Tonking New Energy Group Holdings has a rock-solid balance sheet (and the debt is of no concern whatsoever). On this view, lenders should feel as safe as the beloved of a black-belt karate master.

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). 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).

Tonking New Energy Group Holdings shareholders face the double whammy of a high net debt to EBITDA ratio (6.0), and fairly weak interest coverage, since EBIT is just 1.8 times the interest expense. The debt burden here is substantial. However, the silver lining was that Tonking New Energy Group Holdings achieved a positive EBIT of HK$5.7m in the last twelve months, an improvement on the prior year's loss. There's no doubt that we learn most about debt from the balance sheet. But it is Tonking New Energy Group Holdings's earnings that will influence how the balance sheet holds up in the future. 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. During the last year, Tonking New Energy Group Holdings burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

Tonking New Energy Group Holdings's conversion of EBIT to free cash flow was a real negative on this analysis, as was its net debt to EBITDA. But its level of total liabilities was significantly redeeming. Looking at all this data makes us feel a little cautious about Tonking New Energy Group Holdings's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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. For instance, we've identified 3 warning signs for Tonking New Energy Group Holdings (1 is significant) 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.