Chung-Hsin Electric and Machinery Manufacturing (TWSE:1513) Seems To Use Debt Quite Sensibly

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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. We can see that Chung-Hsin Electric and Machinery Manufacturing Corp. (TWSE:1513) does use debt in its business. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Chung-Hsin Electric and Machinery Manufacturing

What Is Chung-Hsin Electric and Machinery Manufacturing's Debt?

You can click the graphic below for the historical numbers, but it shows that Chung-Hsin Electric and Machinery Manufacturing had NT$12.0b of debt in September 2024, down from NT$13.0b, one year before. However, because it has a cash reserve of NT$2.55b, its net debt is less, at about NT$9.46b.

How Strong Is Chung-Hsin Electric and Machinery Manufacturing's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Chung-Hsin Electric and Machinery Manufacturing had liabilities of NT$17.4b due within 12 months and liabilities of NT$13.2b due beyond that. Offsetting these obligations, it had cash of NT$2.55b as well as receivables valued at NT$8.63b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$19.4b.

While this might seem like a lot, it is not so bad since Chung-Hsin Electric and Machinery Manufacturing has a market capitalization of NT$72.9b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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.

Chung-Hsin Electric and Machinery Manufacturing's net debt to EBITDA ratio of about 1.8 suggests only moderate use of debt. And its strong interest cover of 27.5 times, makes us even more comfortable. Notably Chung-Hsin Electric and Machinery Manufacturing's EBIT was pretty flat over the last year. We would prefer to see some earnings growth, because that always helps diminish debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Chung-Hsin Electric and Machinery Manufacturing can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

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. During the last three years, Chung-Hsin Electric and Machinery Manufacturing generated free cash flow amounting to a very robust 90% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Our View

Happily, Chung-Hsin Electric and Machinery Manufacturing's impressive interest cover implies it has the upper hand on its debt. And the good news does not stop there, as its conversion of EBIT to free cash flow also supports that impression! Taking all this data into account, it seems to us that Chung-Hsin Electric and Machinery Manufacturing takes a pretty sensible approach to debt. While that brings some risk, it can also enhance returns for shareholders. 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. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Chung-Hsin Electric and Machinery Manufacturing you should know about.

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. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.