Depo Auto Parts Industrial (TPE:6605) Use Of Debt Could Be Considered Risky

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Depo Auto Parts Industrial Co., Ltd. (TPE:6605) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Depo Auto Parts Industrial

What Is Depo Auto Parts Industrial's Net Debt?

As you can see below, Depo Auto Parts Industrial had NT$13.2b of debt at September 2020, down from NT$14.2b a year prior. However, it also had NT$3.13b in cash, and so its net debt is NT$10.1b.

How Healthy Is Depo Auto Parts Industrial's Balance Sheet?

The latest balance sheet data shows that Depo Auto Parts Industrial had liabilities of NT$10.9b due within a year, and liabilities of NT$7.30b falling due after that. Offsetting these obligations, it had cash of NT$3.13b as well as receivables valued at NT$2.57b due within 12 months. So it has liabilities totalling NT$12.5b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of NT$8.90b, we think shareholders really should watch Depo Auto Parts Industrial's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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.

Depo Auto Parts Industrial's debt is 2.9 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. Worse, Depo Auto Parts Industrial's EBIT was down 36% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Depo Auto Parts Industrial's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, while the tax-man may adore accounting profits, lenders only accept 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, Depo Auto Parts Industrial recorded free cash flow of 48% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

To be frank both Depo Auto Parts Industrial's level of total liabilities and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But at least its conversion of EBIT to free cash flow is not so bad. Taking into account all the aforementioned factors, it looks like Depo Auto Parts Industrial has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Consider for instance, the ever-present spectre of investment risk. We've identified 5 warning signs with Depo Auto Parts Industrial (at least 2 which don't sit too well with us) , and understanding them should be part of your investment process.

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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