We Think Prime Oil Chemical Service (TPE:2904) Can Stay On Top Of Its Debt

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. Importantly, Prime Oil Chemical Service Corporation (TPE:2904) does carry debt. But should shareholders be worried about its use of debt?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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 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, because it has a cash reserve of NT$135.4m, its net debt is less, at about NT$259.2m.

A Look At Prime Oil Chemical Service's Liabilities

We can see from the most recent balance sheet that Prime Oil Chemical Service had liabilities of NT$335.2m falling due within a year, and liabilities of NT$267.4m due beyond that. On the other hand, it had cash of NT$135.4m and NT$36.0m worth of receivables due within a year. 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$1.75b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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.

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 you could argue it is no more threatened by its debt than an elephant is by a mouse. The good news is that Prime Oil Chemical Service has increased its EBIT by 2.6% over twelve months, which should ease any concerns about debt repayment. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Prime Oil Chemical Service 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Prime Oil Chemical Service recorded negative free cash flow, in total. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

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. When we consider all the factors mentioned above, we do feel a bit cautious about Prime Oil Chemical Service's use of debt. 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. However, not all investment risk resides within the balance sheet - far from it. Consider risks, for instance. Every company has them, and we've spotted 2 warning signs for Prime Oil Chemical Service you should know about.

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. 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.
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