Is Shenmao Technology (TPE:3305) A Risky Investment?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 note that Shenmao Technology Inc (TPE:3305) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth 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 Shenmao Technology

How Much Debt Does Shenmao Technology Carry?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Shenmao Technology had NT$2.43b of debt, an increase on NT$2.15b, over one year. However, because it has a cash reserve of NT$897.7m, its net debt is less, at about NT$1.53b.

How Strong Is Shenmao Technology's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Shenmao Technology had liabilities of NT$2.25b due within 12 months and liabilities of NT$771.6m due beyond that. Offsetting this, it had NT$897.7m in cash and NT$1.83b in receivables that were due within 12 months. So it has liabilities totalling NT$289.8m more than its cash and near-term receivables, combined.

Since publicly traded Shenmao Technology shares are worth a total of NT$3.95b, 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.

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.

Strangely Shenmao Technology has a sky high EBITDA ratio of 5.1, implying high debt, but a strong interest coverage of 14.3. So either it has access to very cheap long term debt or that interest expense is going to grow! We note that Shenmao Technology grew its EBIT by 27% in the last year, and that should make it easier to pay down debt, going forward. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Shenmao Technology 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent three years, Shenmao Technology recorded free cash flow of 50% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

Happily, Shenmao Technology's impressive interest cover implies it has the upper hand on its debt. But we must concede we find its net debt to EBITDA has the opposite effect. Taking all this data into account, it seems to us that Shenmao Technology takes a pretty sensible approach to debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. 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. For example, we've discovered 5 warning signs for Shenmao Technology (2 make us uncomfortable!) that you should be aware of before investing here.

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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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.
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