Is Lung Hwa Electronics (TPE:2424) A Risky Investment?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 note that Lung Hwa Electronics Co., Ltd. (TPE:2424) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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 examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Lung Hwa Electronics

What Is Lung Hwa Electronics's Net Debt?

As you can see below, at the end of September 2020, Lung Hwa Electronics had NT$211.2m of debt, up from NT$1.48m a year ago. Click the image for more detail. However, because it has a cash reserve of NT$12.4m, its net debt is less, at about NT$198.8m.

How Healthy Is Lung Hwa Electronics's Balance Sheet?

According to the last reported balance sheet, Lung Hwa Electronics had liabilities of NT$173.9m due within 12 months, and liabilities of NT$241.9m due beyond 12 months. On the other hand, it had cash of NT$12.4m and NT$2.35m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$401.1m.

Given this deficit is actually higher than the company's market capitalization of NT$356.4m, we think shareholders really should watch Lung Hwa Electronics's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Lung Hwa Electronics 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.

Over 12 months, Lung Hwa Electronics reported revenue of NT$19m, which is a gain of 18%, although it did not report any earnings before interest and tax. We usually like to see faster growth from unprofitable companies, but each to their own.

Caveat Emptor

Over the last twelve months Lung Hwa Electronics produced an earnings before interest and tax (EBIT) loss. Indeed, it lost a very considerable NT$165m at the EBIT level. Considering that alongside the liabilities mentioned above make us nervous about the company. We'd want to see some strong near-term improvements before getting too interested in the stock. Not least because it burned through NT$130m in negative free cash flow over the last year. That means it's on the risky side of things. 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. Be aware that Lung Hwa Electronics is showing 5 warning signs in our investment analysis , and 3 of those don't sit too well with us...

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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