Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that '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 Shihlin Electric & Engineering Corporation (TPE:1503) does use debt in its business. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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. 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.
What Is Shihlin Electric & Engineering's Debt?
You can click the graphic below for the historical numbers, but it shows that Shihlin Electric & Engineering had NT$3.56b of debt in September 2020, down from NT$3.72b, one year before. However, it also had NT$3.01b in cash, and so its net debt is NT$552.7m.
How Healthy Is Shihlin Electric & Engineering's Balance Sheet?
According to the last reported balance sheet, Shihlin Electric & Engineering had liabilities of NT$12.0b due within 12 months, and liabilities of NT$3.64b due beyond 12 months. Offsetting this, it had NT$3.01b in cash and NT$8.19b in receivables that were due within 12 months. So it has liabilities totalling NT$4.39b more than its cash and near-term receivables, combined.
Since publicly traded Shihlin Electric & Engineering shares are worth a total of NT$24.7b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Shihlin Electric & Engineering has net debt of just 0.21 times EBITDA, suggesting it could ramp leverage without breaking a sweat. But the really cool thing is that it actually managed to receive more interest than it paid, over the last year. So there's no doubt this company can take on debt while staying cool as a cucumber. Also good is that Shihlin Electric & Engineering grew its EBIT at 11% over the last year, further increasing its ability to manage debt. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Shihlin Electric & Engineering 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, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Shihlin Electric & Engineering generated free cash flow amounting to a very robust 90% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.
Shihlin Electric & Engineering's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And that's just the beginning of the good news since its conversion of EBIT to free cash flow is also very heartening. Looking at the bigger picture, we think Shihlin Electric & Engineering's use of debt seems quite reasonable and we're not concerned about it. After all, sensible leverage can boost returns on equity. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Shihlin Electric & Engineering you should know about.
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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