Is Lung Hwa Electronics (TPE:2424) Using Debt In A Risky Way?

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. As with many other companies Lung Hwa Electronics Co., Ltd. (TPE:2424) makes use of debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Lung Hwa Electronics

How Much Debt Does Lung Hwa Electronics Carry?

The image below, which you can click on for greater detail, shows that at December 2020 Lung Hwa Electronics had debt of NT$143.9m, up from NT$93.4m in one year. However, because it has a cash reserve of NT$51.5m, its net debt is less, at about NT$92.3m.

How Strong Is Lung Hwa Electronics' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Lung Hwa Electronics had liabilities of NT$244.1m due within 12 months and liabilities of NT$210.3m due beyond that. Offsetting this, it had NT$51.5m in cash and NT$64.6m in receivables that were due within 12 months. So it has liabilities totalling NT$338.2m more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of NT$313.2m, 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. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Lung Hwa Electronics will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Over 12 months, Lung Hwa Electronics made a loss at the EBIT level, and saw its revenue drop to NT$18m, which is a fall of 22%. To be frank that doesn't bode well.

Caveat Emptor

While Lung Hwa Electronics's falling revenue is about as heartwarming as a wet blanket, arguably its earnings before interest and tax (EBIT) loss is even less appealing. Indeed, it lost a very considerable NT$181m at the EBIT level. Considering that alongside the liabilities mentioned above make us nervous about the company. It would need to improve its operations quickly for us to be interested in it. Not least because it had negative free cash flow of NT$109m over the last twelve months. So suffice it to say we consider the stock to be risky. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 4 warning signs with Lung Hwa Electronics (at least 3 which are concerning) , and understanding them should be part of your investment process.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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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