Is Leofoo Development (TWSE:2705) Using Too Much Debt?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. Importantly, Leofoo Development Co., Ltd. (TWSE:2705) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Leofoo Development

What Is Leofoo Development's Net Debt?

The image below, which you can click on for greater detail, shows that at December 2023 Leofoo Development had debt of NT$5.06b, up from NT$4.81b in one year. However, it does have NT$350.2m in cash offsetting this, leading to net debt of about NT$4.71b.

How Strong Is Leofoo Development's Balance Sheet?

We can see from the most recent balance sheet that Leofoo Development had liabilities of NT$1.18b falling due within a year, and liabilities of NT$9.63b due beyond that. Offsetting this, it had NT$350.2m in cash and NT$39.0m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$10.4b.

This deficit casts a shadow over the NT$3.81b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Leofoo Development would likely require a major re-capitalisation if it had to pay its creditors today.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).

Leofoo Development shareholders face the double whammy of a high net debt to EBITDA ratio (15.7), and fairly weak interest coverage, since EBIT is just 0.38 times the interest expense. The debt burden here is substantial. One redeeming factor for Leofoo Development is that it turned last year's EBIT loss into a gain of NT$76m, over the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Leofoo Development's earnings that will influence how the balance sheet holds up in the future. 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Happily for any shareholders, Leofoo Development actually produced more free cash flow than EBIT over the last year. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

To be frank both Leofoo Development's interest cover and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Overall, it seems to us that Leofoo Development's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. While Leofoo Development didn't make a statutory profit in the last year, its positive EBIT suggests that profitability might not be far away. Click here to see if its earnings are heading in the right direction, over the medium term.

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. 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.