Walsin Lihwa (TPE:1605) Seems To Use Debt Quite Sensibly

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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. Importantly, Walsin Lihwa Corporation (TPE:1605) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Walsin Lihwa

What Is Walsin Lihwa's Debt?

The image below, which you can click on for greater detail, shows that at December 2020 Walsin Lihwa had debt of NT$44.2b, up from NT$36.0b in one year. However, it also had NT$13.3b in cash, and so its net debt is NT$30.8b.

How Healthy Is Walsin Lihwa's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Walsin Lihwa had liabilities of NT$31.5b due within 12 months and liabilities of NT$32.8b due beyond that. On the other hand, it had cash of NT$13.3b and NT$15.9b worth of receivables due within a year. So its liabilities total NT$35.0b more than the combination of its cash and short-term receivables.

Walsin Lihwa has a market capitalization of NT$77.5b, 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Walsin Lihwa has a debt to EBITDA ratio of 3.2, which signals significant debt, but is still pretty reasonable for most types of business. But its EBIT was about 44.1 times its interest expense, implying the company isn't really paying a high cost to maintain that level of debt. Even were the low cost to prove unsustainable, that is a good sign. Importantly, Walsin Lihwa grew its EBIT by 82% over the last twelve months, and that growth will make it easier to handle its debt. 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 Walsin Lihwa can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

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. Considering the last three years, Walsin Lihwa actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Our View

Both Walsin Lihwa's ability to to cover its interest expense with its EBIT and its EBIT growth rate gave us comfort that it can handle its debt. In contrast, our confidence was undermined by its apparent struggle to convert EBIT to free cash flow. Looking at all this data makes us feel a little cautious about Walsin Lihwa's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 4 warning signs for Walsin Lihwa (1 is concerning) you should be aware of.

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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