These 4 Measures Indicate That Cathay Consolidated (TPE:1342) Is Using Debt Safely

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. As with many other companies Cathay Consolidated, Inc. (TPE:1342) makes use of debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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.

Check out our latest analysis for Cathay Consolidated

How Much Debt Does Cathay Consolidated Carry?

The image below, which you can click on for greater detail, shows that Cathay Consolidated had debt of NT$210.3m at the end of December 2020, a reduction from NT$273.2m over a year. But on the other hand it also has NT$447.6m in cash, leading to a NT$237.3m net cash position.

How Healthy Is Cathay Consolidated's Balance Sheet?

We can see from the most recent balance sheet that Cathay Consolidated had liabilities of NT$297.1m falling due within a year, and liabilities of NT$219.2m due beyond that. Offsetting this, it had NT$447.6m in cash and NT$203.0m in receivables that were due within 12 months. So it actually has NT$134.3m more liquid assets than total liabilities.

This short term liquidity is a sign that Cathay Consolidated could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Cathay Consolidated has more cash than debt is arguably a good indication that it can manage its debt safely.

Also good is that Cathay Consolidated grew its EBIT at 13% over the last year, further increasing its ability to manage debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Cathay Consolidated's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. Cathay Consolidated may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last three years, Cathay Consolidated produced sturdy free cash flow equating to 65% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Summing up

While it is always sensible to investigate a company's debt, in this case Cathay Consolidated has NT$237.3m in net cash and a decent-looking balance sheet. So we don't think Cathay Consolidated's use of debt is risky. 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. Be aware that Cathay Consolidated is showing 2 warning signs in our investment analysis , 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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