Is China Steel Structure (TPE:2013) Using Too Much Debt?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. We note that China Steel Structure Co., Ltd. (TPE:2013) does have debt on its balance sheet. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for China Steel Structure

How Much Debt Does China Steel Structure Carry?

The image below, which you can click on for greater detail, shows that China Steel Structure had debt of NT$4.40b at the end of December 2020, a reduction from NT$4.91b over a year. However, because it has a cash reserve of NT$875.5m, its net debt is less, at about NT$3.53b.

How Healthy Is China Steel Structure's Balance Sheet?

The latest balance sheet data shows that China Steel Structure had liabilities of NT$8.96b due within a year, and liabilities of NT$957.6m falling due after that. Offsetting these obligations, it had cash of NT$875.5m as well as receivables valued at NT$2.53b due within 12 months. So it has liabilities totalling NT$6.51b more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of NT$9.07b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe 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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Strangely China Steel Structure has a sky high EBITDA ratio of 7.9, implying high debt, but a strong interest coverage of 11.1. So either it has access to very cheap long term debt or that interest expense is going to grow! Notably, China Steel Structure's EBIT launched higher than Elon Musk, gaining a whopping 282% on last year. The balance sheet is clearly the area to focus on when you are analysing debt. But it is China Steel Structure's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Happily for any shareholders, China Steel Structure actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

China Steel Structure's conversion of EBIT to free cash flow suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But we must concede we find its net debt to EBITDA has the opposite effect. Looking at all the aforementioned factors together, it strikes us that China Steel Structure can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should learn about the 4 warning signs we've spotted with China Steel Structure (including 1 which is concerning) .

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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