We Think Cheng Fwa Industrial (GTSM:5426) Can Stay On Top Of Its 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 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. As with many other companies Cheng Fwa Industrial Co., Ltd. (GTSM:5426) makes use of debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Cheng Fwa Industrial

What Is Cheng Fwa Industrial's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Cheng Fwa Industrial had NT$149.8m of debt, an increase on none, over one year. However, it does have NT$690.5m in cash offsetting this, leading to net cash of NT$540.7m.

How Healthy Is Cheng Fwa Industrial's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Cheng Fwa Industrial had liabilities of NT$514.4m due within 12 months and liabilities of NT$199.8m due beyond that. Offsetting these obligations, it had cash of NT$690.5m as well as receivables valued at NT$471.4m due within 12 months. So it actually has NT$447.7m more liquid assets than total liabilities.

This surplus suggests that Cheng Fwa Industrial is using debt in a way that is appears to be both safe and conservative. Because it has plenty of assets, it is unlikely to have trouble with its lenders. Simply put, the fact that Cheng Fwa Industrial has more cash than debt is arguably a good indication that it can manage its debt safely.

It is just as well that Cheng Fwa Industrial's load is not too heavy, because its EBIT was down 28% over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Cheng Fwa Industrial 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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Cheng Fwa Industrial has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. During the last three years, Cheng Fwa Industrial produced sturdy free cash flow equating to 75% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Summing up

While it is always sensible to investigate a company's debt, in this case Cheng Fwa Industrial has NT$540.7m in net cash and a decent-looking balance sheet. The cherry on top was that in converted 75% of that EBIT to free cash flow, bringing in NT$53m. So is Cheng Fwa Industrial's debt a risk? It doesn't seem so to us. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 5 warning signs for Cheng Fwa Industrial (1 is concerning!) that you should be aware of before investing here.

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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