Shuz Tung Machinery Industrial (GTSM:4537) Has A Somewhat Strained Balance Sheet

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 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, Shuz Tung Machinery Industrial Co., Ltd. (GTSM:4537) does carry debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Shuz Tung Machinery Industrial

How Much Debt Does Shuz Tung Machinery Industrial Carry?

You can click the graphic below for the historical numbers, but it shows that Shuz Tung Machinery Industrial had NT$1.44b of debt in June 2020, down from NT$1.70b, one year before. On the flip side, it has NT$348.9m in cash leading to net debt of about NT$1.09b.

How Healthy Is Shuz Tung Machinery Industrial's Balance Sheet?

The latest balance sheet data shows that Shuz Tung Machinery Industrial had liabilities of NT$2.37b due within a year, and liabilities of NT$153.8m falling due after that. Offsetting these obligations, it had cash of NT$348.9m as well as receivables valued at NT$1.18b due within 12 months. So it has liabilities totalling NT$996.1m more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of NT$1.46b, so it does suggest shareholders should keep an eye on Shuz Tung Machinery Industrial's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Strangely Shuz Tung Machinery Industrial has a sky high EBITDA ratio of 5.5, implying high debt, but a strong interest coverage of 13.2. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. The bad news is that Shuz Tung Machinery Industrial saw its EBIT decline by 14% over the last year. 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 Shuz Tung Machinery Industrial'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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Shuz Tung Machinery Industrial reported free cash flow worth 16% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

On the face of it, Shuz Tung Machinery Industrial's EBIT growth rate left us tentative about the stock, and its net debt to EBITDA was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Looking at the bigger picture, it seems clear to us that Shuz Tung Machinery Industrial's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. 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. Take risks, for example - Shuz Tung Machinery Industrial has 2 warning signs we think you should be aware of.

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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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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