Formosa Petrochemical (TWSE:6505) Seems To Use Debt Rather Sparingly

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.' 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, Formosa Petrochemical Corporation (TWSE:6505) does carry debt. But should shareholders be worried about its use of debt?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Formosa Petrochemical

What Is Formosa Petrochemical's Net Debt?

The image below, which you can click on for greater detail, shows that Formosa Petrochemical had debt of NT$28.5b at the end of June 2024, a reduction from NT$29.9b over a year. However, its balance sheet shows it holds NT$74.9b in cash, so it actually has NT$46.4b net cash.

How Strong Is Formosa Petrochemical's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Formosa Petrochemical had liabilities of NT$66.2b due within 12 months and liabilities of NT$30.2b due beyond that. Offsetting this, it had NT$74.9b in cash and NT$66.9b in receivables that were due within 12 months. So it can boast NT$45.3b more liquid assets than total liabilities.

This short term liquidity is a sign that Formosa Petrochemical could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Formosa Petrochemical has more cash than debt is arguably a good indication that it can manage its debt safely.

Although Formosa Petrochemical made a loss at the EBIT level, last year, it was also good to see that it generated NT$22b in EBIT over the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Formosa Petrochemical can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Formosa Petrochemical has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the most recent year, Formosa Petrochemical recorded free cash flow worth 72% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Formosa Petrochemical has net cash of NT$46.4b, as well as more liquid assets than liabilities. The cherry on top was that in converted 72% of that EBIT to free cash flow, bringing in NT$16b. So is Formosa Petrochemical's debt a risk? It doesn't seem so to us. 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. For example, we've discovered 1 warning sign for Formosa Petrochemical that you should be aware of before investing here.

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.

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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.