Is Tongtai Machine & Tool (TWSE:4526) Using Too Much Debt?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Tongtai Machine & Tool Co., Ltd. (TWSE:4526) does use debt in its business. But the more important question is: how much risk is that debt creating?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Tongtai Machine & Tool

How Much Debt Does Tongtai Machine & Tool Carry?

The image below, which you can click on for greater detail, shows that Tongtai Machine & Tool had debt of NT$4.87b at the end of September 2023, a reduction from NT$5.40b over a year. However, it also had NT$1.40b in cash, and so its net debt is NT$3.47b.

How Strong Is Tongtai Machine & Tool's Balance Sheet?

According to the last reported balance sheet, Tongtai Machine & Tool had liabilities of NT$7.60b due within 12 months, and liabilities of NT$1.47b due beyond 12 months. Offsetting these obligations, it had cash of NT$1.40b as well as receivables valued at NT$3.01b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$4.66b.

This is a mountain of leverage relative to its market capitalization of NT$5.66b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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

Weak interest cover of 0.56 times and a disturbingly high net debt to EBITDA ratio of 11.3 hit our confidence in Tongtai Machine & Tool like a one-two punch to the gut. The debt burden here is substantial. More concerning, Tongtai Machine & Tool saw its EBIT drop by 5.2% in the last twelve months. If that earnings trend continues the company will face an uphill battle to pay off its debt. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Tongtai Machine & Tool will need earnings to service that debt. 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 last two years, Tongtai Machine & Tool actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

To be frank both Tongtai Machine & Tool's net debt to EBITDA and its track record of covering its interest expense with its EBIT make us rather uncomfortable with its debt levels. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Tongtai Machine & Tool stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 3 warning signs for Tongtai Machine & Tool (2 are a bit concerning!) that you should be aware of before investing here.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.