Here's Why Sunny Friend Environmental Technology (TPE:8341) Can Manage Its Debt Responsibly

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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, Sunny Friend Environmental Technology Co., Ltd. (TPE:8341) does carry 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. If things get really bad, the lenders can take control of the business. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Sunny Friend Environmental Technology

How Much Debt Does Sunny Friend Environmental Technology Carry?

The image below, which you can click on for greater detail, shows that at December 2020 Sunny Friend Environmental Technology had debt of NT$3.44b, up from NT$1.25b in one year. However, because it has a cash reserve of NT$1.32b, its net debt is less, at about NT$2.12b.

A Look At Sunny Friend Environmental Technology's Liabilities

We can see from the most recent balance sheet that Sunny Friend Environmental Technology had liabilities of NT$2.10b falling due within a year, and liabilities of NT$3.63b due beyond that. Offsetting these obligations, it had cash of NT$1.32b as well as receivables valued at NT$458.5m due within 12 months. So its liabilities total NT$3.95b more than the combination of its cash and short-term receivables.

Given Sunny Friend Environmental Technology has a market capitalization of NT$25.5b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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). 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).

Sunny Friend Environmental Technology has a low net debt to EBITDA ratio of only 1.4. And its EBIT easily covers its interest expense, being 56.7 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Fortunately, Sunny Friend Environmental Technology grew its EBIT by 3.7% in the last year, making that debt load look even more manageable. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Sunny Friend Environmental Technology 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 company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent three years, Sunny Friend Environmental Technology recorded free cash flow of 27% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

On our analysis Sunny Friend Environmental Technology's interest cover should signal that it won't have too much trouble with its debt. However, our other observations weren't so heartening. For instance it seems like it has to struggle a bit to convert EBIT to free cash flow. When we consider all the elements mentioned above, it seems to us that Sunny Friend Environmental Technology is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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 instance, we've identified 3 warning signs for Sunny Friend Environmental Technology (1 is a bit concerning) you should be aware of.

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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