Is TAIWAN CHELIC (TPE:4555) A Risky Investment?

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.' 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. As with many other companies TAIWAN CHELIC Co., Ltd. (TPE:4555) makes use of debt. 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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for TAIWAN CHELIC

How Much Debt Does TAIWAN CHELIC Carry?

The image below, which you can click on for greater detail, shows that at September 2020 TAIWAN CHELIC had debt of NT$1.62b, up from NT$1.15b in one year. However, it also had NT$495.1m in cash, and so its net debt is NT$1.12b.

How Strong Is TAIWAN CHELIC's Balance Sheet?

We can see from the most recent balance sheet that TAIWAN CHELIC had liabilities of NT$1.17b falling due within a year, and liabilities of NT$816.0m due beyond that. Offsetting these obligations, it had cash of NT$495.1m as well as receivables valued at NT$515.1m due within 12 months. So its liabilities total NT$980.7m more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since TAIWAN CHELIC has a market capitalization of NT$4.09b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

With net debt to EBITDA of 4.0 TAIWAN CHELIC has a fairly noticeable amount of debt. But the high interest coverage of 8.3 suggests it can easily service that debt. Importantly, TAIWAN CHELIC grew its EBIT by 89% over the last twelve months, and that growth will make it easier to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine TAIWAN CHELIC's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, TAIWAN CHELIC burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

TAIWAN CHELIC's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered were considerably better. In particular, we are dazzled with its EBIT growth rate. When we consider all the factors mentioned above, we do feel a bit cautious about TAIWAN CHELIC's use of debt. 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. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example - TAIWAN CHELIC has 2 warning signs we think you should be aware of.

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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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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