Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. As with many other companies CHTC Fong's International Company Limited (HKG:641) makes use of debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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 CHTC Fong's International

What Is CHTC Fong's International's Net Debt?

As you can see below, at the end of December 2018, CHTC Fong's International had HK$1.89b of debt, up from HK$1.16b a year ago. Click the image for more detail. However, it also had HK$586.8m in cash, and so its net debt is HK$1.31b.

How Healthy Is CHTC Fong's International's Balance Sheet?

We can see from the most recent balance sheet that CHTC Fong's International had liabilities of HK$2.73b falling due within a year, and liabilities of HK$482.9m due beyond that. Offsetting this, it had HK$586.8m in cash and HK$561.3m in receivables that were due within 12 months. So its liabilities total HK$2.07b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the HK$649.1m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. After all, CHTC Fong's International would likely require a major re-capitalisation if it had to pay its creditors today.

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).