Is Chow Tai Fook Jewellery Group (HKG:1929) A Risky Investment?

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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Chow Tai Fook Jewellery Group Limited (HKG:1929) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Chow Tai Fook Jewellery Group

What Is Chow Tai Fook Jewellery Group's Debt?

As you can see below, at the end of September 2024, Chow Tai Fook Jewellery Group had HK$28.5b of debt, up from HK$26.4b a year ago. Click the image for more detail. However, because it has a cash reserve of HK$3.84b, its net debt is less, at about HK$24.6b.

A Look At Chow Tai Fook Jewellery Group's Liabilities

According to the last reported balance sheet, Chow Tai Fook Jewellery Group had liabilities of HK$58.1b due within 12 months, and liabilities of HK$2.41b due beyond 12 months. On the other hand, it had cash of HK$3.84b and HK$5.85b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$50.8b.

This deficit is considerable relative to its market capitalization of HK$67.9b, so it does suggest shareholders should keep an eye on Chow Tai Fook Jewellery Group's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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).

We'd say that Chow Tai Fook Jewellery Group's moderate net debt to EBITDA ratio ( being 2.3), indicates prudence when it comes to debt. And its strong interest cover of 20.6 times, makes us even more comfortable. Notably Chow Tai Fook Jewellery Group's EBIT was pretty flat over the last year. Ideally it can diminish its debt load by kick-starting earnings growth. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Chow Tai Fook Jewellery Group's ability to maintain a healthy balance sheet going forward. 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 company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Chow Tai Fook Jewellery Group actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

Both Chow Tai Fook Jewellery Group's ability to to cover its interest expense with its EBIT and its conversion of EBIT to free cash flow gave us comfort that it can handle its debt. Having said that, its level of total liabilities somewhat sensitizes us to potential future risks to the balance sheet. When we consider all the elements mentioned above, it seems to us that Chow Tai Fook Jewellery Group is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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. For example - Chow Tai Fook Jewellery Group has 3 warning signs we think you should be aware of.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.