Is the development of China Tianbao Group (HKG:1427) using too much debt?

Legendary fund manager Li Lu (whom Charlie Munger once backed) once said, “The biggest risk in investing is not price volatility, but whether you will suffer a permanent loss of capital. When we think of a company’s risk, we always like to look at its use of debt, because over-indebtedness can lead to ruin. We note that China Tianbao Group Development Company Limited (HKG:1427) has a debt on its balance sheet. But does this debt worry shareholders?

When is debt dangerous?

Debt and other liabilities become risky for a business when it cannot easily meet those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company cannot meet its legal debt repayment obligations, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is when a company has to dilute shareholders at a cheap share price just to keep debt under control. That said, the most common situation is when a company manages its debt reasonably well – and to its own benefit. When we look at debt levels, we first consider cash and debt levels, together.

Our analysis indicates that 1427 is potentially overvalued!

What is China Tianbao Group Development’s net debt?

As you can see below, China Tianbao Group Development had a debt of 822.0 million Canadian yen in June 2022, roughly the same as the previous year. You can click on the graph for more details. However, since it has a cash reserve of 316.8 million Canadian yen, its net debt is less, at approximately 505.2 million Canadian yen.

How strong is China Tianbao Group Development’s balance sheet?

Zooming in on the latest balance sheet data, we can see that China Tianbao Group Development had liabilities of 5.44 billion Canadian yen due within 12 months and liabilities of 169.7 million domestic yen due beyond. In compensation for these obligations, it had cash of 316.8 million yen as well as receivables valued at 2.30 billion yen due within 12 months. Thus, its liabilities outweigh the sum of its cash and (short-term) receivables of 3.00 billion Canadian yen.

Given that this deficit is actually greater than the company’s market capitalization of 2.12 trillion Canadian yen, we think shareholders should really be watching China Tianbao Group Development’s debt levels, like a parent watching their child riding a bicycle for the first time. In theory, extremely large dilution would be required if the company were forced to repay its debts by raising capital at the current share price.

We measure a company’s leverage against its earning power by looking at its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and calculating how easily its earnings before interest and taxes (EBIT ) covers its interest charge (interest coverage). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.

While we are not concerned about China Tianbao Group Development’s net debt to EBITDA ratio of 4.4, we believe its extremely low interest coverage of 2.0 times is a sign of high leverage. Shareholders should therefore probably be aware that interest charges seem to have had a real impact on the company lately. Worse still, China Tianbao Group Development’s EBIT was down 69% from a year ago. If earnings continue to follow this trajectory, paying off that debt will be harder than convincing us to run a marathon in the rain. The balance sheet is clearly the area to focus on when analyzing debt. But it is the profits of China Tianbao Group Development that will influence the balance sheet in the future. So, when considering debt, it is definitely worth looking at the earnings trend. Click here for an interactive preview.

Finally, a company can only repay its debts with cold hard cash, not with book profits. We must therefore clearly examine whether this EBIT generates a corresponding free cash flow. Over the past three years, China Tianbao Group Development’s free cash flow has been 40% of its EBIT, less than expected. This low cash conversion makes debt management more difficult.

Our point of view

To be frank, China Tianbao Group Development’s level of total liabilities and its history of (non-)growth in its EBIT make us rather uncomfortable with its level of leverage. That said, its ability to convert EBIT to free cash flow isn’t all that worrying. After reviewing the data points discussed, we believe that China Tianbao Group Development has too much debt. That kind of risk is acceptable to some, but it certainly doesn’t float our boat. There is no doubt that we learn the most about debt from the balance sheet. But at the end of the day, every business can contain risks that exist outside of the balance sheet. Example: we have identified 1 China Tianbao Group Development Warning Sign you should be aware.

In the end, sometimes it’s easier to focus on companies that don’t even need to take on debt. Readers can access a list of growth stocks with no net debt 100% freeat present.

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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.