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 FuSheng Precision Co., Ltd. (TPE:6670) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
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. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.
What Is FuSheng Precision's Net Debt?
As you can see below, at the end of September 2020, FuSheng Precision had NT$1.52b of debt, up from NT$747.9m a year ago. Click the image for more detail. But on the other hand it also has NT$3.13b in cash, leading to a NT$1.60b net cash position.
How Healthy Is FuSheng Precision's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that FuSheng Precision had liabilities of NT$4.70b due within 12 months and liabilities of NT$497.1m due beyond that. Offsetting this, it had NT$3.13b in cash and NT$2.47b in receivables that were due within 12 months. So it actually has NT$390.3m more liquid assets than total liabilities.
Having regard to FuSheng Precision's size, it seems that its liquid assets are well balanced with its total liabilities. So while it's hard to imagine that the NT$22.9b company is struggling for cash, we still think it's worth monitoring its balance sheet. Succinctly put, FuSheng Precision boasts net cash, so it's fair to say it does not have a heavy debt load!
In fact FuSheng Precision's saving grace is its low debt levels, because its EBIT has tanked 25% in the last twelve months. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine FuSheng Precision's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. FuSheng Precision may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last three years, FuSheng Precision produced sturdy free cash flow equating to 61% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
While it is always sensible to investigate a company's debt, in this case FuSheng Precision has NT$1.60b in net cash and a decent-looking balance sheet. So we don't have any problem with FuSheng Precision's use of debt. 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 FuSheng Precision is showing 1 warning sign in our investment analysis , you should know about...
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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