Nankang Rubber TireLtd (TWSE:2101) Takes On Some Risk With Its Use Of Debt

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 Nankang Rubber Tire Corp.,Ltd. (TWSE:2101) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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 think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Nankang Rubber TireLtd

What Is Nankang Rubber TireLtd's Debt?

As you can see below, at the end of September 2024, Nankang Rubber TireLtd had NT$20.3b of debt, up from NT$19.4b a year ago. Click the image for more detail. However, it does have NT$1.61b in cash offsetting this, leading to net debt of about NT$18.7b.

How Healthy Is Nankang Rubber TireLtd's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Nankang Rubber TireLtd had liabilities of NT$17.8b due within 12 months and liabilities of NT$12.5b due beyond that. On the other hand, it had cash of NT$1.61b and NT$2.70b worth of receivables due within a year. So its liabilities total NT$25.9b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of NT$38.2b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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).

Nankang Rubber TireLtd's net debt is 4.3 times its EBITDA, which is a significant but still reasonable amount of leverage. But its EBIT was about 26.4 times its interest expense, implying the company isn't really paying a high cost to maintain that level of debt. Even were the low cost to prove unsustainable, that is a good sign. Notably, Nankang Rubber TireLtd's EBIT launched higher than Elon Musk, gaining a whopping 3,639% on last year. When analysing debt levels, the balance sheet is the obvious place to start. But it is Nankang Rubber TireLtd's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last two years, Nankang Rubber TireLtd saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

We feel some trepidation about Nankang Rubber TireLtd's difficulty conversion of EBIT to free cash flow, but we've got positives to focus on, too. For example, its interest cover and EBIT growth rate give us some confidence in its ability to manage its debt. We think that Nankang Rubber TireLtd's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. 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. For example, we've discovered 2 warning signs for Nankang Rubber TireLtd that you should be aware of before investing here.

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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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.