Berkshire Hathaway’s Charlie Munger-backed outside fund manager Li Lu is quick to say, “The biggest risk in investing isn’t price volatility, but whether you’re going to suffer a permanent loss of capital “. So it seems smart money knows that debt – which is usually involved in bankruptcies – is a very important factor when you’re assessing a company’s risk. Above all, Texhong Textile Group Limited (HKG:2678) is in debt. But does this debt worry shareholders?
What risk does debt carry?
Debt helps a business until the business struggles to pay it back, either with new capital or with free cash flow. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are mercilessly liquidated by their bankers. Although not too common, we often see companies in debt permanently diluting their shareholders because lenders force them to raise capital at a ridiculous price. That said, the most common situation is when a company manages its debt reasonably well – and to its own benefit. The first thing to do when considering how much debt a business has is to look at its cash flow and debt together.
Check out our latest analysis for Texhong Textile Group
What is Texhong Textile Group’s debt?
The graph below, which you can click on for more details, shows that Texhong Textile Group had a debt of 7.24 billion yen in December 2021; about the same as the previous year. However, he also had 2.51 billion yen in cash, so his net debt is 4.74 billion yen.
How healthy is Texhong Textile Group’s balance sheet?
We can see from the most recent balance sheet that Texhong Textile Group had liabilities of 10.1 billion yen due within one year, and liabilities of 3.75 billion yen due beyond. In compensation for these obligations, it had cash of 2.51 billion yen as well as receivables valued at 2.65 billion yen due within 12 months. It therefore has liabilities totaling 8.69 billion Canadian yen more than its cash and short-term receivables, combined.
Given that this deficit is actually greater than the company’s market capitalization of 7.03 billion Canadian yen, we think shareholders should really be watching Texhong Textile Group’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.
Texhong Textile Group’s net debt is only 1.1 times its EBITDA. And its EBIT covers its interest charges 21.2 times. So we’re pretty relaxed about his super-conservative use of debt. Even better, Texhong Textile Group increased its EBIT by 331% last year, which is an impressive improvement. This boost will make it even easier to pay off debt in the future. When analyzing debt levels, the balance sheet is the obvious starting point. But ultimately, the company’s future profitability will decide whether Texhong Textile Group can strengthen its balance sheet over time. So if you are focused on the future, you can check out this free report showing analyst earnings forecast.
But our last consideration is also important, because a company cannot pay debt with paper profits; he needs cash. We must therefore clearly examine whether this EBIT generates a corresponding free cash flow. Over the past three years, Texhong Textile Group has recorded free cash flow of 56% of its EBIT, which is about normal given that free cash flow excludes interest and taxes. This cold hard cash allows him to reduce his debt whenever he wants.
Our point of view
Texhong Textile Group’s interest coverage was a real advantage in this analysis, as was its EBIT growth rate. But truth be told, his total passive level had us biting our nails. When we consider all the elements mentioned above, it seems to us that Texhong Textile Group manages its debt quite well. But be warned: we believe debt levels are high enough to warrant continued monitoring. The balance sheet is clearly the area to focus on when analyzing debt. However, not all investment risks reside on the balance sheet, far from it. Know that Texhong Textile Group shows 3 warning signs in our investment analysis and 1 of them is a little worrying…
In the end, it’s often best to focus on companies that aren’t in debt. You can access our special list of these companies (all with a track record of earnings growth). It’s free.
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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.