Is China Steel Structure (TPE:2013) A Risky Investment?

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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. We can see that China Steel Structure Co., Ltd. (TPE:2013) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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, 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.

See our latest analysis for China Steel Structure

What Is China Steel Structure's Debt?

As you can see below, China Steel Structure had NT$4.47b of debt at September 2020, down from NT$5.63b a year prior. However, because it has a cash reserve of NT$729.0m, its net debt is less, at about NT$3.74b.

How Strong Is China Steel Structure's Balance Sheet?

We can see from the most recent balance sheet that China Steel Structure had liabilities of NT$9.27b falling due within a year, and liabilities of NT$959.2m due beyond that. On the other hand, it had cash of NT$729.0m and NT$2.67b worth of receivables due within a year. So it has liabilities totalling NT$6.82b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of NT$5.56b, we think shareholders really should watch China Steel Structure's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

China Steel Structure has a rather high debt to EBITDA ratio of 11.4 which suggests a meaningful debt load. However, its interest coverage of 5.1 is reasonably strong, which is a good sign. Notably, China Steel Structure's EBIT launched higher than Elon Musk, gaining a whopping 149% on last year. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since China Steel Structure 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 clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, China Steel Structure actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

China Steel Structure's net debt to EBITDA was a real negative on this analysis, although the other factors we considered were considerably better. There's no doubt that its ability to to convert EBIT to free cash flow is pretty flash. When we consider all the factors mentioned above, we do feel a bit cautious about China Steel Structure's use of debt. 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 example, we've discovered 3 warning signs for China Steel Structure 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.

If you decide to trade China Steel Structure, use the lowest-cost* platform that is rated #1 Overall by Barron’s, Interactive Brokers. Trade stocks, options, futures, forex, bonds and funds on 135 markets, all from a single integrated account. Promoted

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.
^*Interactive Brokers Rated Lowest Cost Broker by StockBrokers.com Annual Online Review 2020

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.