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.' 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. As with many other companies Far Eastern New Century Corporation (TPE:1402) makes use of debt. But is this debt a concern to shareholders?
When Is Debt Dangerous?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Far Eastern New Century's Net Debt?
As you can see below, at the end of September 2020, Far Eastern New Century had NT$266.4b of debt, up from NT$205.0b a year ago. Click the image for more detail. However, it does have NT$41.5b in cash offsetting this, leading to net debt of about NT$224.9b.
How Strong Is Far Eastern New Century's Balance Sheet?
We can see from the most recent balance sheet that Far Eastern New Century had liabilities of NT$125.6b falling due within a year, and liabilities of NT$215.9b due beyond that. Offsetting this, it had NT$41.5b in cash and NT$34.5b in receivables that were due within 12 months. So its liabilities total NT$265.6b more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the NT$143.2b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, Far Eastern New Century would probably need a major re-capitalization if its creditors were to demand repayment.
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.
With a net debt to EBITDA ratio of 7.6, it's fair to say Far Eastern New Century does have a significant amount of debt. However, its interest coverage of 3.6 is reasonably strong, which is a good sign. Even worse, Far Eastern New Century saw its EBIT tank 25% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Far Eastern New Century can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
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 last three years, Far Eastern New Century 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.
To be frank both Far Eastern New Century's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. And even its net debt to EBITDA fails to inspire much confidence. Considering everything we've mentioned above, it's fair to say that Far Eastern New Century is carrying heavy debt load. If you play with fire you risk getting burnt, so we'd probably give this stock a wide berth. 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. Be aware that Far Eastern New Century is showing 3 warning signs in our investment analysis , and 1 of those can't be ignored...
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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