These 4 Measures Indicate That Lily Textile (TPE:1443) Is Using Debt In A Risky Way

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. As with many other companies Lily Textile Co., Ltd. (TPE:1443) makes use of debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Lily Textile

What Is Lily Textile's Net Debt?

The image below, which you can click on for greater detail, shows that at December 2020 Lily Textile had debt of NT$4.22b, up from NT$3.91b in one year. However, because it has a cash reserve of NT$292.9m, its net debt is less, at about NT$3.93b.

A Look At Lily Textile's Liabilities

According to the last reported balance sheet, Lily Textile had liabilities of NT$3.66b due within 12 months, and liabilities of NT$1.24b due beyond 12 months. Offsetting these obligations, it had cash of NT$292.9m as well as receivables valued at NT$245.9m due within 12 months. So it has liabilities totalling NT$4.36b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the NT$1.52b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. After all, Lily Textile would likely require a major re-capitalisation if it had to pay its creditors today.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). 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).

Lily Textile shareholders face the double whammy of a high net debt to EBITDA ratio (26.3), and fairly weak interest coverage, since EBIT is just 1.2 times the interest expense. The debt burden here is substantial. Even more troubling is the fact that Lily Textile actually let its EBIT decrease by 9.9% over the last year. If that earnings trend continues the company will face an uphill battle to pay off its debt. 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 Lily 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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last two years, Lily Textile burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

To be frank both Lily Textile's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. And even its net debt to EBITDA fails to inspire much confidence. Considering all the factors previously mentioned, we think that Lily Textile really is carrying too much debt. To our minds, that means the stock is rather high risk, and probably one to avoid; but to each their own (investing) style. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Lily Textile you should know about.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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