Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that '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 Tsinghua Tongfang Co., Ltd. (SHSE:600100) does use debt in its business. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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 examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Tsinghua Tongfang Carry?
You can click the graphic below for the historical numbers, but it shows that Tsinghua Tongfang had CN¥16.3b of debt in June 2024, down from CN¥19.5b, one year before. However, because it has a cash reserve of CN¥6.66b, its net debt is less, at about CN¥9.61b.
A Look At Tsinghua Tongfang's Liabilities
Zooming in on the latest balance sheet data, we can see that Tsinghua Tongfang had liabilities of CN¥18.7b due within 12 months and liabilities of CN¥11.6b due beyond that. Offsetting this, it had CN¥6.66b in cash and CN¥9.48b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥14.2b.
This is a mountain of leverage relative to its market capitalization of CN¥15.8b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe 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). 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).
Tsinghua Tongfang shareholders face the double whammy of a high net debt to EBITDA ratio (23.1), and fairly weak interest coverage, since EBIT is just 0.30 times the interest expense. The debt burden here is substantial. Worse, Tsinghua Tongfang's EBIT was down 75% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. There's no doubt that we learn most about debt from the balance sheet. But it is Tsinghua Tongfang'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.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. In the last two years, Tsinghua Tongfang's free cash flow amounted to 39% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
Our View
On the face of it, Tsinghua Tongfang's interest cover left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But at least its conversion of EBIT to free cash flow is not so bad. After considering the datapoints discussed, we think Tsinghua Tongfang has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 1 warning sign for Tsinghua Tongfang you should be aware of.
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.
