The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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. As with many other companies Chow Tai Fook Jewellery Group Limited (HKG:1929) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is Chow Tai Fook Jewellery Group's Net Debt?

As you can see below, at the end of March 2024, Chow Tai Fook Jewellery Group had HK$28.6b of debt, up from HK$20.9b a year ago. Click the image for more detail. On the flip side, it has HK$7.70b in cash leading to net debt of about HK$20.9b.

How Healthy Is Chow Tai Fook Jewellery Group's Balance Sheet?

According to the last reported balance sheet, Chow Tai Fook Jewellery Group had liabilities of HK$57.5b due within 12 months, and liabilities of HK$4.55b due beyond 12 months. Offsetting these obligations, it had cash of HK$7.70b as well as receivables valued at HK$6.84b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$47.5b.

This deficit is considerable relative to its market capitalization of HK$68.5b, so it does suggest shareholders should keep an eye on Chow Tai Fook Jewellery Group's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Chow Tai Fook Jewellery Group's net debt to EBITDA ratio of about 2.0 suggests only moderate use of debt. And its commanding EBIT of 19.9 times its interest expense, implies the debt load is as light as a peacock feather. We note that Chow Tai Fook Jewellery Group grew its EBIT by 21% in the last year, and that should make it easier to pay down debt, going forward. When analysing debt levels, the balance sheet is the obvious place to start. 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 want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Happily for any shareholders, Chow Tai Fook Jewellery Group actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

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. But, on a more sombre note, we are a little concerned by its level of total liabilities. Taking all this data into account, it seems to us that Chow Tai Fook Jewellery Group takes a pretty sensible approach to debt. While that brings some risk, it can also enhance returns for shareholders. 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. Be aware that Chow Tai Fook Jewellery Group is showing 2 warning signs in our investment analysis , you should know about...

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com