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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that China Tianbao Group Development Company Limited (HKG:1427) does use debt in its business. But the real question is whether this debt is making the company risky.
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. 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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.
See our latest analysis for China Tianbao Group Development
The image below, which you can click on for greater detail, shows that at June 2024 China Tianbao Group Development had debt of CN¥1.40b, up from CN¥1.06b in one year. On the flip side, it has CN¥361.5m in cash leading to net debt of about CN¥1.04b.
Zooming in on the latest balance sheet data, we can see that China Tianbao Group Development had liabilities of CN¥4.79b due within 12 months and liabilities of CN¥533.6m due beyond that. Offsetting this, it had CN¥361.5m in cash and CN¥1.92b in receivables that were due within 12 months. So it has liabilities totalling CN¥3.05b more than its cash and near-term receivables, combined.
The deficiency here weighs heavily on the CN¥135.1m 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, China Tianbao Group Development would likely require a major re-capitalisation if it had to pay its creditors today.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Weak interest cover of 1.00 times and a disturbingly high net debt to EBITDA ratio of 14.2 hit our confidence in China Tianbao Group Development like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. One redeeming factor for China Tianbao Group Development is that it turned last year's EBIT loss into a gain of CN¥67m, over the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since China Tianbao Group Development 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 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, China Tianbao Group Development 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.
To be frank both China Tianbao Group Development's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least its EBIT growth rate is not so bad. Considering all the factors previously mentioned, we think that China Tianbao Group Development really is carrying too much debt. To our minds, that means the stock is rather high risk, and probably one to avoid; but to each their own (investing) style. 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 example, we've discovered 4 warning signs for China Tianbao Group Development (2 shouldn't be ignored!) that you should be aware of before investing here.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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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.