Is Hocheng (TPE:1810) Using Too Much Debt?

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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, Hocheng Corporation (TPE:1810) does carry debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Hocheng

What Is Hocheng's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Hocheng had NT$3.30b of debt in September 2020, down from NT$3.49b, one year before. However, because it has a cash reserve of NT$1.30b, its net debt is less, at about NT$2.00b.

How Strong Is Hocheng's Balance Sheet?

According to the last reported balance sheet, Hocheng had liabilities of NT$3.85b due within 12 months, and liabilities of NT$1.26b due beyond 12 months. Offsetting these obligations, it had cash of NT$1.30b as well as receivables valued at NT$1.42b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$2.39b.

This is a mountain of leverage relative to its market capitalization of NT$3.66b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Hocheng 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.

In the last year Hocheng had a loss before interest and tax, and actually shrunk its revenue by 5.9%, to NT$5.3b. That's not what we would hope to see.

Caveat Emptor

Over the last twelve months Hocheng produced an earnings before interest and tax (EBIT) loss. To be specific the EBIT loss came in at NT$8.3m. When we look at that and recall the liabilities on its balance sheet, relative to cash, it seems unwise to us for the company to have any debt. Quite frankly we think the balance sheet is far from match-fit, although it could be improved with time. Surprisingly, we note that it actually reported positive free cash flow of NT$476m and a profit of NT$62m. So one might argue that there's still a chance it can get things on the right track. 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. Consider for instance, the ever-present spectre of investment risk. We've identified 3 warning signs with Hocheng (at least 2 which don't sit too well with us) , and understanding them should be part of your investment process.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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