David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Chow Tai Fook Jewellery Group Limited (HKG:1929) does carry debt. But is this debt a concern to shareholders?
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.
What Is Chow Tai Fook Jewellery Group's Debt?
You can click the graphic below for the historical numbers, but it shows that as of March 2019 Chow Tai Fook Jewellery Group had HK$18.1b of debt, an increase on HK$13.3b, over one year. On the flip side, it has HK$8.08b in cash leading to net debt of about HK$9.99b.
How Healthy Is Chow Tai Fook Jewellery Group's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Chow Tai Fook Jewellery Group had liabilities of HK$27.5b due within 12 months and liabilities of HK$3.36b due beyond that. Offsetting this, it had HK$8.08b in cash and HK$5.85b in receivables that were due within 12 months. So it has liabilities totalling HK$16.9b more than its cash and near-term receivables, combined.
This deficit isn't so bad because Chow Tai Fook Jewellery Group is worth HK$66.5b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.
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.
Chow Tai Fook Jewellery Group's net debt is only 1.3 times its EBITDA. And its EBIT covers its interest expense a whopping 27.3 times over. So we're pretty relaxed about its super-conservative use of debt. And we also note warmly that Chow Tai Fook Jewellery Group grew its EBIT by 20% last year, making its debt load easier to handle. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Chow Tai Fook Jewellery Group can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
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, Chow Tai Fook Jewellery Group generated free cash flow amounting to a very robust 85% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.
Chow Tai Fook Jewellery Group's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And the good news does not stop there, as its conversion of EBIT to free cash flow also supports that impression! Looking at the bigger picture, we think Chow Tai Fook Jewellery Group's use of debt seems quite reasonable and we're not concerned about it. While debt does bring risk, when used wisely it can also bring a higher return on equity. Another positive for shareholders is that it pays dividends. So if you like receiving those dividend payments, check Chow Tai Fook Jewellery Group's dividend history, without delay!
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.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
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.