Is De Licacy Industrial (TPE:1464) A Risky Investment?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. As with many other companies De Licacy Industrial Co., Ltd. (TPE:1464) makes use of debt. But should shareholders be worried about its use of debt?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for De Licacy Industrial

What Is De Licacy Industrial's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2020 De Licacy Industrial had debt of NT$10.6b, up from NT$10.2b in one year. However, because it has a cash reserve of NT$1.14b, its net debt is less, at about NT$9.50b.

How Strong Is De Licacy Industrial's Balance Sheet?

We can see from the most recent balance sheet that De Licacy Industrial had liabilities of NT$8.75b falling due within a year, and liabilities of NT$3.20b due beyond that. Offsetting these obligations, it had cash of NT$1.14b as well as receivables valued at NT$2.00b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$8.81b.

When you consider that this deficiency exceeds the company's NT$7.02b market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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 (11.6), and fairly weak interest coverage, since EBIT is just 2.0 times the interest expense. This means we'd consider it to have a heavy debt load. Worse, De Licacy Industrial's EBIT was down 46% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. There's no doubt that we learn most about debt from the balance sheet. But it is De Licacy Industrial's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, De Licacy Industrial saw substantial negative free cash flow, in total. 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 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 even its interest cover fails to inspire much confidence. Considering all the factors previously mentioned, we think that De Licacy Industrial really is carrying too much debt. To us, that makes the stock rather risky, like walking through a dog park with your eyes closed. But some investors may feel differently. 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. Take risks, for example - De Licacy Industrial has 5 warning signs (and 2 which are concerning) we think 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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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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