Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Tu Yi Holding Company Limited (HKG:1701) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own 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. 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.
How Much Debt Does Tu Yi Holding Carry?
As you can see below, at the end of June 2019, Tu Yi Holding had CN¥104.3m of debt, up from CN¥70.3m a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥50.9m, its net debt is less, at about CN¥53.4m.
How Healthy Is Tu Yi Holding's Balance Sheet?
We can see from the most recent balance sheet that Tu Yi Holding had liabilities of CN¥102.7m falling due within a year, and liabilities of CN¥68.1m due beyond that. On the other hand, it had cash of CN¥50.9m and CN¥38.0m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥82.0m.
While this might seem like a lot, it is not so bad since Tu Yi Holding has a market capitalization of CN¥309.4m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Tu Yi Holding has a low net debt to EBITDA ratio of only 0.94. And its EBIT covers its interest expense a whopping 16.2 times over. So we're pretty relaxed about its super-conservative use of debt. In addition to that, we're happy to report that Tu Yi Holding has boosted its EBIT by 82%, thus reducing the spectre of future debt repayments. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Tu Yi Holding'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.
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. During the last three years, Tu Yi Holding 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.
Tu Yi Holding's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered were considerably better There's no doubt that its ability to cover its interest expense with its EBIT is pretty flash. Considering this range of data points, we think Tu Yi Holding is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. Over time, share prices tend to follow earnings per share, so if you're interested in Tu Yi Holding, you may well want to click here to check an interactive graph of its earnings per share history.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.