Y.C.C. Parts Mfg (TPE:1339) Seems To Use Debt Quite Sensibly

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that Y.C.C. Parts Mfg. Co., Ltd. (TPE:1339) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Y.C.C. Parts Mfg

What Is Y.C.C. Parts Mfg's Debt?

The image below, which you can click on for greater detail, shows that Y.C.C. Parts Mfg had debt of NT$1.20b at the end of September 2020, a reduction from NT$1.31b over a year. However, because it has a cash reserve of NT$1.12b, its net debt is less, at about NT$80.7m.

A Look At Y.C.C. Parts Mfg's Liabilities

The latest balance sheet data shows that Y.C.C. Parts Mfg had liabilities of NT$1.20b due within a year, and liabilities of NT$615.2m falling due after that. On the other hand, it had cash of NT$1.12b and NT$617.1m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$76.0m.

Since publicly traded Y.C.C. Parts Mfg shares are worth a total of NT$3.12b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).

Y.C.C. Parts Mfg has a low net debt to EBITDA ratio of only 0.12. And its EBIT easily covers its interest expense, being 439 times the size. So we're pretty relaxed about its super-conservative use of debt. But the bad news is that Y.C.C. Parts Mfg has seen its EBIT plunge 17% in the last twelve months. If that rate of decline in earnings continues, the company could find itself in a tight spot. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Y.C.C. Parts Mfg will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Y.C.C. Parts Mfg 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

The good news is that Y.C.C. Parts Mfg's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But the stark truth is that we are concerned by its EBIT growth rate. When we consider the range of factors above, it looks like Y.C.C. Parts Mfg is pretty sensible with its use of debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 4 warning signs for Y.C.C. Parts Mfg you should be aware of, and 1 of them is potentially serious.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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