De Licacy Industrial (TPE:1464) Use Of Debt Could Be Considered Risky

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.' 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. We can see that De Licacy Industrial Co., Ltd. (TPE:1464) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for De Licacy Industrial

What Is De Licacy Industrial's Net Debt?

The chart below, which you can click on for greater detail, shows that De Licacy Industrial had NT$10.7b in debt in December 2020; about the same as the year before. However, it also had NT$1.29b in cash, and so its net debt is NT$9.46b.

How Strong Is De Licacy Industrial's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that De Licacy Industrial had liabilities of NT$9.11b due within 12 months and liabilities of NT$3.28b due beyond that. Offsetting this, it had NT$1.29b in cash and NT$2.25b in receivables that were due within 12 months. So its liabilities total NT$8.85b more than the combination of its cash and short-term receivables.

Given this deficit is actually higher than the company's market capitalization of NT$6.69b, we think shareholders really should watch De Licacy Industrial's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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).

De Licacy Industrial shareholders face the double whammy of a high net debt to EBITDA ratio (16.5), and fairly weak interest coverage, since EBIT is just 0.094 times the interest expense. This means we'd consider it to have a heavy debt load. Worse, De Licacy Industrial's EBIT was down 98% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since De Licacy Industrial 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, De Licacy Industrial saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both De Licacy Industrial's conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. And furthermore, its net debt to EBITDA also fails to instill confidence. It looks to us like De Licacy Industrial carries a significant balance sheet burden. If you play with fire you risk getting burnt, so we'd probably give this stock a wide berth. 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. For example, we've discovered 3 warning signs for De Licacy Industrial (2 shouldn't be ignored!) that you should be aware of before investing here.

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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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.
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