Tongguan Gold Group (HKG: 340) takes certain risks with its use of debt

Some say volatility, rather than debt, is the best way to view risk as an investor, but Warren Buffett said “volatility is far from risk.” It’s only natural to consider a company’s balance sheet when looking at its level of risk, as debt is often involved when a business collapses. Mostly, Tongguan Gold Group Limited (KG: 340) bears the debt. But the most important question is: what risk does this debt create?

What risk does debt entail?

Debt and other liabilities become risky for a business when it cannot easily meet these obligations, either with free cash flow or by raising capital at an attractive price. If things really go wrong, lenders can take over the business. However, a more common (but still painful) scenario is that he has to raise new equity at low cost, thereby constantly diluting shareholders. By replacing dilution, however, debt can be a very good tool for companies that need capital to invest in growth at high rates of return. The first step in examining a company’s debt levels is to consider its cash flow and debt together.

See our latest analysis for Tongguan Gold Group

How much debt does Tongguan Gold Group have?

As you can see below, at the end of December 2020, Tongguan Gold Group had a debt of HK $ 304.0 million, up from HK $ 161.3 million a year ago. Click on the image for more details. However, he also had HK $ 160.3 million in cash, so his net debt is HK $ 143.7 million.

SEHK: 340 History of debt to equity May 24, 2021

A look at the liabilities of Tongguan Gold Group

According to the latest published balance sheet, Tongguan Gold Group had a liability of HK $ 790.6 million due within 12 months and a liability of HK $ 1.04 billion due beyond 12 months. On the other hand, he had HK $ 160.3 million in cash and HK $ 14.7 million in receivables due within a year. It therefore has liabilities totaling HK $ 1.65 billion more than its cash and short-term receivables combined.

This deficit casts a shadow over the HK $ 1.09 billion company like a towering colossus of mere mortals. So we would be watching its record closely, without a doubt. After all, Tongguan Gold Group would likely need a major recapitalization if it were to pay its creditors today.

In order to measure a company’s debt relative to its profits, we calculate its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and its profit before interest and taxes (EBIT) divided by its interest. debtors (its interest coverage). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.

Tongguan Gold Group’s net debt to EBITDA ratio of around 2.4 suggests only a moderate use of debt. And its high interest coverage of 1k times, makes us even more comfortable. Notably, Tongguan Gold Group recorded a loss in EBIT level last year, but improved it to a positive EBIT of HK $ 5.8 million in the past twelve months. The balance sheet is clearly the area you need to focus on when analyzing debt. But you can’t look at debt in isolation; since Tongguan Gold Group will need income to repay this debt. So, when considering debt, it is really worth looking at the profit trend. Click here for an interactive snapshot.

Finally, while the IRS may love accounting profits, lenders only accept hard cash. It is therefore worth checking to what extent earnings before interest and taxes (EBIT) are backed by free cash flow. In the past year, Tongguan Gold Group recorded substantial total negative free cash flow. While this may be the result of spending on growth, it makes debt much riskier.

Our point of view

To be frank, Tongguan Gold Group’s level of total liabilities and its track record of converting EBIT to free cash flow makes us rather uncomfortable with its debt levels. But at least it’s decent enough to cover its interest costs with its EBIT; it’s encouraging. Overall, it seems to us that Tongguan Gold Group’s balance sheet is really a risk for the company. For this reason, we are fairly cautious about the stock, and we believe shareholders should keep a close eye on its liquidity. Even though Tongguan Gold Group lost money on the bottom line, its positive EBIT suggests that the company itself has potential. Then you may want to check how revenues have evolved over the past few years.

At the end of the day, it’s often best to focus on businesses with no net debt. You can access our special list of these companies (all with a history of profit growth). It’s free.

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