These 4 Measures Indicate That Ten Ren Tea (TPE:1233) Is Using Debt Reasonably Well

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.' 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 can see that Ten Ren Tea Co., Ltd. (TPE:1233) does use debt in its business. But is this debt a concern to shareholders?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth 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 Ten Ren Tea

What Is Ten Ren Tea's Debt?

As you can see below, at the end of September 2020, Ten Ren Tea had NT$275.0m of debt, up from NT$110.0m a year ago. Click the image for more detail. However, its balance sheet shows it holds NT$341.9m in cash, so it actually has NT$66.9m net cash.

How Healthy Is Ten Ren Tea's Balance Sheet?

We can see from the most recent balance sheet that Ten Ren Tea had liabilities of NT$624.7m falling due within a year, and liabilities of NT$340.1m due beyond that. Offsetting these obligations, it had cash of NT$341.9m as well as receivables valued at NT$189.9m due within 12 months. So it has liabilities totalling NT$433.0m more than its cash and near-term receivables, combined.

Since publicly traded Ten Ren Tea shares are worth a total of NT$3.14b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. While it does have liabilities worth noting, Ten Ren Tea also has more cash than debt, so we're pretty confident it can manage its debt safely.

The modesty of its debt load may become crucial for Ten Ren Tea if management cannot prevent a repeat of the 50% cut to EBIT over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Ten Ren Tea will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Ten Ren Tea has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last three years, Ten Ren Tea actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Summing up

Although Ten Ren Tea's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of NT$66.9m. The cherry on top was that in converted 147% of that EBIT to free cash flow, bringing in NT$269m. So we don't have any problem with Ten Ren Tea's use of debt. 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. To that end, you should learn about the 3 warning signs we've spotted with Ten Ren Tea (including 1 which is a bit unpleasant) .

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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