Hong Ho Precision TextileLtd (TPE:1446) Takes On Some Risk With Its Use Of Debt

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that Hong Ho Precision Textile Co.,Ltd. (TPE:1446) does have debt on its balance sheet. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Hong Ho Precision TextileLtd

What Is Hong Ho Precision TextileLtd's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Hong Ho Precision TextileLtd had NT$2.48b of debt, an increase on NT$2.22b, over one year. However, it also had NT$279.2m in cash, and so its net debt is NT$2.20b.

How Strong Is Hong Ho Precision TextileLtd's Balance Sheet?

According to the last reported balance sheet, Hong Ho Precision TextileLtd had liabilities of NT$457.8m due within 12 months, and liabilities of NT$2.14b due beyond 12 months. On the other hand, it had cash of NT$279.2m and NT$26.0m worth of receivables due within a year. So its liabilities total NT$2.29b more than the combination of its cash and short-term receivables.

Hong Ho Precision TextileLtd has a market capitalization of NT$3.95b, so it could very likely raise cash to ameliorate 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 measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

As it happens Hong Ho Precision TextileLtd has a fairly concerning net debt to EBITDA ratio of 135 but very strong interest coverage of 15.2. So either it has access to very cheap long term debt or that interest expense is going to grow! Notably, Hong Ho Precision TextileLtd made a loss at the EBIT level, last year, but improved that to positive EBIT of NT$14m in the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Hong Ho Precision TextileLtd's earnings that will influence how the balance sheet holds up in the future. 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. During the last year, Hong Ho Precision TextileLtd 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

On the face of it, Hong Ho Precision TextileLtd's net debt to EBITDA left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Once we consider all the factors above, together, it seems to us that Hong Ho Precision TextileLtd's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example - Hong Ho Precision TextileLtd has 1 warning sign we think you should be aware of.

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.

When trading Hong Ho Precision TextileLtd or any other investment, use the platform considered by many to be the Professional's Gateway to the Worlds Market, Interactive Brokers. You get the lowest-cost* trading on stocks, options, futures, forex, bonds and funds worldwide from a single integrated account. Promoted

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.
^*Interactive Brokers Rated Lowest Cost Broker by StockBrokers.com Annual Online Review 2020

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.