Here's Why Bright Sheland International (GTSM:4556) Has A Meaningful Debt Burden

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.' 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 can see that Bright Sheland International Co., Ltd. (GTSM:4556) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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.

View our latest analysis for Bright Sheland International

What Is Bright Sheland International's Net Debt?

As you can see below, at the end of September 2020, Bright Sheland International had NT$583.4m of debt, up from NT$226.5m a year ago. Click the image for more detail. However, it also had NT$295.5m in cash, and so its net debt is NT$287.9m.

How Healthy Is Bright Sheland International's Balance Sheet?

We can see from the most recent balance sheet that Bright Sheland International had liabilities of NT$303.5m falling due within a year, and liabilities of NT$409.8m due beyond that. On the other hand, it had cash of NT$295.5m and NT$110.2m worth of receivables due within a year. So its liabilities total NT$307.7m more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Bright Sheland International is worth NT$1.41b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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

Bright Sheland International has a debt to EBITDA ratio of 3.5, which signals significant debt, but is still pretty reasonable for most types of business. However, its interest coverage of 11.1 is very high, suggesting that the interest expense on the debt is currently quite low. One way Bright Sheland International could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 11%, as it did over the last year. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Bright Sheland International will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Bright Sheland International saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

Bright Sheland International's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. In particular, its interest cover was re-invigorating. We think that Bright Sheland International'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. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should learn about the 4 warning signs we've spotted with Bright Sheland International (including 2 which is don't sit too well with us) .

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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