Tainan Enterprise (Cayman) (TPE:5906) Has A Pretty Healthy Balance Sheet

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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Tainan Enterprise (Cayman) Co., Limited (TPE:5906) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

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. 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, 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.

See our latest analysis for Tainan Enterprise (Cayman)

How Much Debt Does Tainan Enterprise (Cayman) Carry?

You can click the graphic below for the historical numbers, but it shows that Tainan Enterprise (Cayman) had NT$247.2m of debt in September 2020, down from NT$411.7m, one year before. However, it also had NT$128.3m in cash, and so its net debt is NT$118.9m.

How Strong Is Tainan Enterprise (Cayman)'s Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Tainan Enterprise (Cayman) had liabilities of NT$608.7m due within 12 months and liabilities of NT$104.1m due beyond that. Offsetting these obligations, it had cash of NT$128.3m as well as receivables valued at NT$153.4m due within 12 months. So its liabilities total NT$431.1m more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Tainan Enterprise (Cayman) is worth NT$1.47b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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).

While Tainan Enterprise (Cayman)'s low debt to EBITDA ratio of 1.2 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 6.0 times last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Unfortunately, Tainan Enterprise (Cayman) saw its EBIT slide 5.9% in the last twelve months. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. When analysing debt levels, the balance sheet is the obvious place to start. But it is Tainan Enterprise (Cayman)'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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Tainan Enterprise (Cayman) actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

On our analysis Tainan Enterprise (Cayman)'s conversion of EBIT to free cash flow should signal that it won't have too much trouble with its debt. But the other factors we noted above weren't so encouraging. For example, its EBIT growth rate makes us a little nervous about its debt. When we consider all the elements mentioned above, it seems to us that Tainan Enterprise (Cayman) is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. 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 instance, we've identified 2 warning signs for Tainan Enterprise (Cayman) that you should be aware of.

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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