These 4 Measures Indicate That Hong Ho Precision TextileLtd (TWSE:1446) Is Using Debt Reasonably Well

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.' 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. Importantly, Hong Ho Precision Textile Co.,Ltd. (TWSE:1446) does carry debt. But is this debt a concern to shareholders?

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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Hong Ho Precision TextileLtd

How Much Debt Does Hong Ho Precision TextileLtd Carry?

The image below, which you can click on for greater detail, shows that Hong Ho Precision TextileLtd had debt of NT$2.07b at the end of March 2024, a reduction from NT$3.16b over a year. However, because it has a cash reserve of NT$464.8m, its net debt is less, at about NT$1.60b.

How Healthy Is Hong Ho Precision TextileLtd's Balance Sheet?

According to the last reported balance sheet, Hong Ho Precision TextileLtd had liabilities of NT$2.63b due within 12 months, and liabilities of NT$24.1m due beyond 12 months. Offsetting this, it had NT$464.8m in cash and NT$10.6m in receivables that were due within 12 months. So its liabilities total NT$2.18b more than the combination of its cash and short-term receivables.

Hong Ho Precision TextileLtd has a market capitalization of NT$6.47b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Hong Ho Precision TextileLtd's net debt is 3.5 times its EBITDA, which is a significant but still reasonable amount of leverage. But its EBIT was about 19.1 times its interest expense, implying the company isn't really paying a high cost to maintain that level of debt. Even were the low cost to prove unsustainable, that is a good sign. We also note that Hong Ho Precision TextileLtd improved its EBIT from a last year's loss to a positive NT$460m. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Hong Ho Precision TextileLtd 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Happily for any shareholders, Hong Ho Precision TextileLtd actually produced more free cash flow than EBIT over the last year. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

The good news is that Hong Ho Precision TextileLtd's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But, on a more sombre note, we are a little concerned by its net debt to EBITDA. Looking at all the aforementioned factors together, it strikes us that Hong Ho Precision TextileLtd can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. 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. We've identified 2 warning signs with Hong Ho Precision TextileLtd , and understanding them should be part of your investment process.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.