These 4 Measures Indicate That Shenmao Technology (TPE:3305) Is Using Debt Reasonably Well

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.' 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 can see that Shenmao Technology Inc (TPE:3305) does use debt in its business. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

View 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, it does have NT$956.1m in cash offsetting this, leading to net debt of about NT$1.47b.

A Look At Shenmao Technology's Liabilities

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 these obligations, it had cash of NT$956.1m as well as receivables valued at NT$1.83b due within 12 months. So its liabilities total NT$231.4m more than the combination of its cash and short-term receivables.

Of course, Shenmao Technology has a market capitalization of NT$3.01b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Shenmao Technology has a debt to EBITDA ratio of 4.9, which signals significant debt, but is still pretty reasonable for most types of business. But its EBIT was about 14.1 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. Also relevant is that Shenmao Technology has grown its EBIT by a very respectable 26% in the last year, thus enhancing its ability to pay down debt. 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 if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

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 most recent three years, Shenmao Technology recorded free cash flow worth 50% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

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. When we consider the range of factors above, it looks like Shenmao Technology is pretty sensible with its use of debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Consider for instance, the ever-present spectre of investment risk. We've identified 5 warning signs with Shenmao Technology (at least 2 which are a bit unpleasant) , and understanding them should be part of your investment process.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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