Is Lan Fa TextileLtd (TPE:1459) Using Too Much Debt?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. We can see that Lan Fa Textile Co.,Ltd. (TPE:1459) does use debt in its business. But the real question is whether this debt is making the company risky.

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. 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.

See our latest analysis for Lan Fa TextileLtd

What Is Lan Fa TextileLtd's Debt?

The image below, which you can click on for greater detail, shows that at September 2020 Lan Fa TextileLtd had debt of NT$3.08b, up from NT$2.90b in one year. However, it does have NT$1.51b in cash offsetting this, leading to net debt of about NT$1.57b.

How Strong Is Lan Fa TextileLtd's Balance Sheet?

According to the last reported balance sheet, Lan Fa TextileLtd had liabilities of NT$2.08b due within 12 months, and liabilities of NT$1.23b due beyond 12 months. Offsetting this, it had NT$1.51b in cash and NT$140.9m in receivables that were due within 12 months. So it has liabilities totalling NT$1.66b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of NT$2.63b, so it does suggest shareholders should keep an eye on Lan Fa TextileLtd's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Lan Fa TextileLtd 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 Lan Fa TextileLtd had a loss before interest and tax, and actually shrunk its revenue by 43%, to NT$1.9b. To be frank that doesn't bode well.

Caveat Emptor

Not only did Lan Fa TextileLtd's revenue slip over the last twelve months, but it also produced negative earnings before interest and tax (EBIT). Indeed, it lost NT$259m at the EBIT level. When we look at that and recall the liabilities on its balance sheet, relative to cash, it seems unwise to us for the company to have any debt. So we think its balance sheet is a little strained, though not beyond repair. For example, we would not want to see a repeat of last year's loss of NT$268m. In the meantime, we consider the stock very risky. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. To that end, you should learn about the 2 warning signs we've spotted with Lan Fa TextileLtd (including 1 which is potentially serious) .

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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