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Tan Chong International (HKG:693) Seems To Use Debt Quite Sensibly

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Tan Chong International Limited (HKG:693) does carry debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Tan Chong International

How Much Debt Does Tan Chong International Carry?

As you can see below, Tan Chong International had HK$3.22b of debt, at December 2019, which is about the same as the year before. You can click the chart for greater detail. However, its balance sheet shows it holds HK$4.66b in cash, so it actually has HK$1.44b net cash.

SEHK:693 Historical Debt April 2nd 2020
SEHK:693 Historical Debt April 2nd 2020

How Healthy Is Tan Chong International's Balance Sheet?

According to the last reported balance sheet, Tan Chong International had liabilities of HK$5.85b due within 12 months, and liabilities of HK$1.12b due beyond 12 months. Offsetting this, it had HK$4.66b in cash and HK$1.95b in receivables that were due within 12 months. So it has liabilities totalling HK$365.0m more than its cash and near-term receivables, combined.

Given Tan Chong International has a market capitalization of HK$3.62b, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. While it does have liabilities worth noting, Tan Chong International also has more cash than debt, so we're pretty confident it can manage its debt safely.

Unfortunately, Tan Chong International saw its EBIT slide 7.8% in the last twelve months. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Tan Chong International will need earnings to service that debt. 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Tan Chong International may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. In the last three years, Tan Chong International's free cash flow amounted to 45% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Summing up

Although Tan Chong International's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of HK$1.44b. So we are not troubled with Tan Chong International's debt use. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Consider for instance, the ever-present spectre of investment risk. We've identified 2 warning signs with Tan Chong International , and understanding them should be part of your investment process.

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.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.

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