Toung Loong Textile MFG (GTSM:4401) Has A Somewhat Strained Balance Sheet

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.' 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. As with many other companies Toung Loong Textile MFG. Co., LTD. (GTSM:4401) makes use of debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Toung Loong Textile MFG

How Much Debt Does Toung Loong Textile MFG Carry?

As you can see below, at the end of September 2020, Toung Loong Textile MFG had NT$3.10b of debt, up from NT$2.62b a year ago. Click the image for more detail. However, it does have NT$824.6m in cash offsetting this, leading to net debt of about NT$2.27b.

How Healthy Is Toung Loong Textile MFG's Balance Sheet?

We can see from the most recent balance sheet that Toung Loong Textile MFG had liabilities of NT$2.38b falling due within a year, and liabilities of NT$1.25b due beyond that. On the other hand, it had cash of NT$824.6m and NT$398.1m worth of receivables due within a year. So its liabilities total NT$2.40b more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Toung Loong Textile MFG is worth NT$4.11b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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).

With a net debt to EBITDA ratio of 5.5, it's fair to say Toung Loong Textile MFG does have a significant amount of debt. But the good news is that it boasts fairly comforting interest cover of 5.4 times, suggesting it can responsibly service its obligations. Importantly, Toung Loong Textile MFG's EBIT fell a jaw-dropping 74% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Toung Loong Textile MFG will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Toung Loong Textile MFG recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

On the face of it, Toung Loong Textile MFG'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. Having said that, its ability to cover its interest expense with its EBIT isn't such a worry. Overall, it seems to us that Toung Loong Textile MFG's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Be aware that Toung Loong Textile MFG is showing 5 warning signs in our investment analysis , and 2 of those are concerning...

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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