Chun Zu Machinery Industry (GTSM:4544) Seems To Use Debt Quite Sensibly

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Chun Zu Machinery Industry Co., Ltd. (GTSM:4544) 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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Chun Zu Machinery Industry

How Much Debt Does Chun Zu Machinery Industry Carry?

The image below, which you can click on for greater detail, shows that at June 2020 Chun Zu Machinery Industry had debt of NT$280.9m, up from NT$215.2m in one year. However, because it has a cash reserve of NT$193.6m, its net debt is less, at about NT$87.3m.

How Strong Is Chun Zu Machinery Industry's Balance Sheet?

The latest balance sheet data shows that Chun Zu Machinery Industry had liabilities of NT$819.2m due within a year, and liabilities of NT$166.6m falling due after that. Offsetting these obligations, it had cash of NT$193.6m as well as receivables valued at NT$482.5m due within 12 months. So it has liabilities totalling NT$309.8m more than its cash and near-term receivables, combined.

Chun Zu Machinery Industry has a market capitalization of NT$1.29b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). 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).

Chun Zu Machinery Industry has a low debt to EBITDA ratio of only 0.63. But the really cool thing is that it actually managed to receive more interest than it paid, over the last year. So it's fair to say it can handle debt like a hotshot teppanyaki chef handles cooking. The modesty of its debt load may become crucial for Chun Zu Machinery Industry if management cannot prevent a repeat of the 46% cut to EBIT 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 Chun Zu Machinery 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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Chun Zu Machinery Industry produced sturdy free cash flow equating to 65% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Chun Zu Machinery Industry's EBIT growth rate was a real negative on this analysis, although the other factors we considered were considerably better. There's no doubt that its ability to to cover its interest expense with its EBIT is pretty flash. When we consider all the elements mentioned above, it seems to us that Chun Zu Machinery Industry is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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. For example, we've discovered 2 warning signs for Chun Zu Machinery Industry 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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