These 4 Measures Indicate That TYC Brother Industrial (TPE:1522) Is Using Debt In A Risky Way

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.' 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 TYC Brother Industrial Co., Ltd. (TPE:1522) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for TYC Brother Industrial

What Is TYC Brother Industrial's Debt?

You can click the graphic below for the historical numbers, but it shows that TYC Brother Industrial had NT$9.81b of debt in September 2020, down from NT$10.4b, one year before. However, it does have NT$984.5m in cash offsetting this, leading to net debt of about NT$8.83b.

A Look At TYC Brother Industrial's Liabilities

We can see from the most recent balance sheet that TYC Brother Industrial had liabilities of NT$6.90b falling due within a year, and liabilities of NT$8.94b due beyond that. Offsetting this, it had NT$984.5m in cash and NT$2.64b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$12.2b.

The deficiency here weighs heavily on the NT$7.49b 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. At the end of the day, TYC Brother Industrial would probably need a major re-capitalization if its creditors were to demand repayment.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

TYC Brother Industrial's debt is 4.6 times its EBITDA, and its EBIT cover its interest expense 2.6 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Even worse, TYC Brother Industrial saw its EBIT tank 52% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since TYC Brother Industrial 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 it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, TYC Brother Industrial reported free cash flow worth 7.5% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

To be frank both TYC Brother Industrial's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. And even its net debt to EBITDA fails to inspire much confidence. We think the chances that TYC Brother Industrial has too much debt a very significant. To our minds, that means the stock is rather high risk, and probably one to avoid; but to each their own (investing) style. 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. Be aware that TYC Brother Industrial is showing 4 warning signs in our investment analysis , and 2 of those are a bit concerning...

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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