We Think Cayman Engley Industrial (TPE:2239) Is Taking Some Risk With Its Debt

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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Cayman Engley Industrial Co., Ltd. (TPE:2239) does carry debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Cayman Engley Industrial

How Much Debt Does Cayman Engley Industrial Carry?

You can click the graphic below for the historical numbers, but it shows that Cayman Engley Industrial had NT$8.44b of debt in December 2020, down from NT$8.97b, one year before. However, it also had NT$4.59b in cash, and so its net debt is NT$3.85b.

How Strong Is Cayman Engley Industrial's Balance Sheet?

We can see from the most recent balance sheet that Cayman Engley Industrial had liabilities of NT$13.7b falling due within a year, and liabilities of NT$5.23b due beyond that. On the other hand, it had cash of NT$4.59b and NT$5.92b worth of receivables due within a year. So it has liabilities totalling NT$8.41b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of NT$13.7b, 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). 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).

Cayman Engley Industrial's net debt is sitting at a very reasonable 1.6 times its EBITDA, while its EBIT covered its interest expense just 4.9 times last year. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. The bad news is that Cayman Engley Industrial saw its EBIT decline by 11% over the last year. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, Cayman Engley Industrial recorded free cash flow of 49% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Cayman Engley Industrial's struggle to grow its EBIT had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. For example, its net debt to EBITDA is relatively strong. When we consider all the factors discussed, it seems to us that Cayman Engley Industrial is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 1 warning sign for Cayman Engley Industrial that you should be aware of.

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.

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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. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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