These 4 Measures Indicate That LongDa Construction & Development (TPE:5519) Is Using Debt Extensively

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.' 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. Importantly, LongDa Construction & Development Corporation (TPE:5519) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for LongDa Construction & Development

How Much Debt Does LongDa Construction & Development Carry?

You can click the graphic below for the historical numbers, but it shows that LongDa Construction & Development had NT$3.06b of debt in September 2020, down from NT$3.64b, one year before. However, it also had NT$747.4m in cash, and so its net debt is NT$2.31b.

A Look At LongDa Construction & Development's Liabilities

According to the last reported balance sheet, LongDa Construction & Development had liabilities of NT$1.76b due within 12 months, and liabilities of NT$2.90b due beyond 12 months. Offsetting this, it had NT$747.4m in cash and NT$283.1m in receivables that were due within 12 months. So it has liabilities totalling NT$3.63b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of NT$3.21b, we think shareholders really should watch LongDa Construction & Development's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

As it happens LongDa Construction & Development has a fairly concerning net debt to EBITDA ratio of 5.4 but very strong interest coverage of 170. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. Shareholders should be aware that LongDa Construction & Development's EBIT was down 43% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. When analysing debt levels, the balance sheet is the obvious place to start. But it is LongDa Construction & Development's earnings that will influence how the balance sheet holds up in the future. 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.

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. Over the most recent three years, LongDa Construction & Development recorded free cash flow worth 77% 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

On the face of it, LongDa Construction & Development's net debt to EBITDA left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Once we consider all the factors above, together, it seems to us that LongDa Construction & Development's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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. For instance, we've identified 4 warning signs for LongDa Construction & Development that you should be aware of.

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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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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