Is Tachia Yung Ho Machine Industry (GTSM:2221) Using Too Much 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. We can see that Tachia Yung Ho Machine Industry Co., Ltd. (GTSM:2221) does use debt in its business. 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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Tachia Yung Ho Machine Industry

What Is Tachia Yung Ho Machine Industry's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Tachia Yung Ho Machine Industry had NT$210.2m of debt in December 2020, down from NT$268.1m, one year before. However, because it has a cash reserve of NT$187.1m, its net debt is less, at about NT$23.2m.

How Strong Is Tachia Yung Ho Machine Industry's Balance Sheet?

We can see from the most recent balance sheet that Tachia Yung Ho Machine Industry had liabilities of NT$353.2m falling due within a year, and liabilities of NT$211.8m due beyond that. On the other hand, it had cash of NT$187.1m and NT$245.4m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$132.5m.

Given Tachia Yung Ho Machine Industry has a market capitalization of NT$1.12b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).

Tachia Yung Ho Machine Industry's net debt is only 0.17 times its EBITDA. And its EBIT covers its interest expense a whopping 22.6 times over. So we're pretty relaxed about its super-conservative use of debt. It is just as well that Tachia Yung Ho Machine Industry's load is not too heavy, because its EBIT was down 32% over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Tachia Yung Ho Machine Industry will need earnings to service that debt. 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Tachia Yung Ho Machine Industry recorded free cash flow worth 69% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Happily, Tachia Yung Ho Machine Industry's impressive interest cover implies it has the upper hand on its debt. But we must concede we find its EBIT growth rate has the opposite effect. Looking at all the aforementioned factors together, it strikes us that Tachia Yung Ho Machine Industry can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. 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. Case in point: We've spotted 2 warning signs for Tachia Yung Ho Machine Industry you should be aware of.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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