Zhong Yang Technology (TPE:6668) Has A Somewhat Strained Balance Sheet

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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that Zhong Yang Technology Co., Ltd. (TPE:6668) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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. 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 Zhong Yang Technology

How Much Debt Does Zhong Yang Technology Carry?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Zhong Yang Technology had NT$876.4m of debt, an increase on NT$730.5m, over one year. On the flip side, it has NT$435.4m in cash leading to net debt of about NT$441.0m.

How Strong Is Zhong Yang Technology's Balance Sheet?

We can see from the most recent balance sheet that Zhong Yang Technology had liabilities of NT$512.3m falling due within a year, and liabilities of NT$881.8m due beyond that. Offsetting these obligations, it had cash of NT$435.4m as well as receivables valued at NT$785.5m due within 12 months. So it has liabilities totalling NT$173.2m more than its cash and near-term receivables, combined.

Given Zhong Yang Technology has a market capitalization of NT$4.10b, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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). 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).

With net debt sitting at just 1.3 times EBITDA, Zhong Yang Technology is arguably pretty conservatively geared. And this view is supported by the solid interest coverage, with EBIT coming in at 8.9 times the interest expense over the last year. But the other side of the story is that Zhong Yang Technology saw its EBIT decline by 7.9% over the last year. That sort of decline, if sustained, will obviously make debt harder to handle. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Zhong Yang Technology's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Zhong Yang Technology saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

Zhong Yang Technology's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. For example, its interest cover is relatively strong. Looking at all the angles mentioned above, it does seem to us that Zhong Yang Technology is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 3 warning signs with Zhong Yang Technology (at least 2 which are a bit concerning) , and understanding them should be part of your investment process.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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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