Prime Oil Chemical Service (TPE:2904) Seems To Use Debt Quite Sensibly

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Prime Oil Chemical Service Corporation (TPE:2904) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Prime Oil Chemical Service

What Is Prime Oil Chemical Service's Debt?

The image below, which you can click on for greater detail, shows that at September 2020 Prime Oil Chemical Service had debt of NT$394.6m, up from NT$250.9m in one year. However, it also had NT$135.4m in cash, and so its net debt is NT$259.2m.

How Strong Is Prime Oil Chemical Service's Balance Sheet?

The latest balance sheet data shows that Prime Oil Chemical Service had liabilities of NT$335.2m due within a year, and liabilities of NT$267.4m falling due after that. Offsetting these obligations, it had cash of NT$135.4m as well as receivables valued at NT$36.0m due within 12 months. So its liabilities total NT$431.2m more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Prime Oil Chemical Service is worth NT$1.94b, and thus could probably raise enough capital to shore up 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.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Prime Oil Chemical Service has a low net debt to EBITDA ratio of only 0.97. And its EBIT covers its interest expense a whopping 63.6 times over. So we're pretty relaxed about its super-conservative use of debt. Fortunately, Prime Oil Chemical Service grew its EBIT by 2.6% in the last year, making that debt load look even more manageable. When analysing debt levels, the balance sheet is the obvious place to start. But it is Prime Oil Chemical Service'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, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Considering the last three years, Prime Oil Chemical Service actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

On our analysis Prime Oil Chemical Service's interest cover should signal that it won't have too much trouble with its debt. But the other factors we noted above weren't so encouraging. To be specific, it seems about as good at converting EBIT to free cash flow as wet socks are at keeping your feet warm. Looking at all this data makes us feel a little cautious about Prime Oil Chemical Service's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Prime Oil Chemical Service is showing 2 warning signs in our investment analysis , you should know about...

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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