These 4 Measures Indicate That Cayman Engley Industrial (TPE:2239) Is Using Debt Extensively

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. Importantly, Cayman Engley Industrial Co., Ltd. (TPE:2239) does carry debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Cayman Engley Industrial

How Much Debt Does Cayman Engley Industrial Carry?

The image below, which you can click on for greater detail, shows that at September 2020 Cayman Engley Industrial had debt of NT$8.72b, up from NT$8.12b in one year. On the flip side, it has NT$3.74b in cash leading to net debt of about NT$4.98b.

How Strong Is Cayman Engley Industrial's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Cayman Engley Industrial had liabilities of NT$12.8b due within 12 months and liabilities of NT$5.08b due beyond that. Offsetting this, it had NT$3.74b in cash and NT$4.79b in receivables that were due within 12 months. So its liabilities total NT$9.32b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of NT$12.7b, so it does suggest shareholders should keep an eye on Cayman Engley Industrial's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Cayman Engley Industrial's net debt is sitting at a very reasonable 2.2 times its EBITDA, while its EBIT covered its interest expense just 4.0 times last year. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. Unfortunately, Cayman Engley Industrial's EBIT flopped 18% over the last four quarters. If that sort of decline is not arrested, then the managing its debt will be harder than selling broccoli flavoured ice-cream for a premium. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Cayman Engley Industrial's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Cayman Engley Industrial recorded free cash flow of 22% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Mulling over Cayman Engley Industrial's attempt at (not) growing its EBIT, we're certainly not enthusiastic. But at least its net debt to EBITDA is not so bad. Overall, it seems to us that Cayman Engley Industrial's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should be aware of the 4 warning signs we've spotted with Cayman Engley Industrial .

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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