Is Rechi Precision (TPE:4532) Using Too Much Debt?

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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Rechi Precision Co., Ltd. (TPE:4532) does use debt in its business. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Rechi Precision

What Is Rechi Precision's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Rechi Precision had NT$7.68b of debt in September 2020, down from NT$9.57b, one year before. However, because it has a cash reserve of NT$4.19b, its net debt is less, at about NT$3.49b.

How Healthy Is Rechi Precision's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Rechi Precision had liabilities of NT$11.9b due within 12 months and liabilities of NT$6.01b due beyond that. On the other hand, it had cash of NT$4.19b and NT$8.71b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$4.97b.

This deficit isn't so bad because Rechi Precision is worth NT$10.6b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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). 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).

We'd say that Rechi Precision's moderate net debt to EBITDA ratio ( being 2.1), indicates prudence when it comes to debt. And its commanding EBIT of 22.8 times its interest expense, implies the debt load is as light as a peacock feather. Shareholders should be aware that Rechi Precision's EBIT was down 22% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Rechi Precision 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Happily for any shareholders, Rechi Precision actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

Rechi Precision's EBIT growth rate was a real negative on this analysis, although the other factors we considered were considerably better. In particular, we are dazzled with its interest cover. Looking at all this data makes us feel a little cautious about Rechi Precision's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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 instance, we've identified 3 warning signs for Rechi Precision (1 is potentially serious) you should be aware of.

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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