Here's Why Tung Ho Textile (TPE:1414) Can Afford Some Debt

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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Tung Ho Textile Co., Ltd. (TPE:1414) does carry debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. 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.

See our latest analysis for Tung Ho Textile

What Is Tung Ho Textile's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Tung Ho Textile had NT$604.6m of debt in September 2020, down from NT$798.2m, one year before. On the flip side, it has NT$484.2m in cash leading to net debt of about NT$120.4m.

How Strong Is Tung Ho Textile's Balance Sheet?

The latest balance sheet data shows that Tung Ho Textile had liabilities of NT$674.4m due within a year, and liabilities of NT$702.4m falling due after that. On the other hand, it had cash of NT$484.2m and NT$53.0m worth of receivables due within a year. So it has liabilities totalling NT$839.6m more than its cash and near-term receivables, combined.

This deficit isn't so bad because Tung Ho Textile is worth NT$2.77b, 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. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Tung Ho Textile 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.

In the last year Tung Ho Textile had a loss before interest and tax, and actually shrunk its revenue by 22%, to NT$662m. To be frank that doesn't bode well.

Caveat Emptor

While Tung Ho Textile's falling revenue is about as heartwarming as a wet blanket, arguably its earnings before interest and tax (EBIT) loss is even less appealing. To be specific the EBIT loss came in at NT$39m. Considering that alongside the liabilities mentioned above does not give us much confidence that company should be using so much debt. Quite frankly we think the balance sheet is far from match-fit, although it could be improved with time. Surprisingly, we note that it actually reported positive free cash flow of NT$36m and a profit of NT$96m. So if we focus on those metrics there seems to be a chance the company will manage its debt without much trouble. 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. Be aware that Tung Ho Textile is showing 3 warning signs in our investment analysis , you should know about...

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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