These 4 Measures Indicate That Eagle Cold Storage Enterprise (GTSM:8905) Is Using Debt Extensively

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. We can see that Eagle Cold Storage Enterprise Co., Ltd. (GTSM:8905) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

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How Much Debt Does Eagle Cold Storage Enterprise Carry?

You can click the graphic below for the historical numbers, but it shows that Eagle Cold Storage Enterprise had NT$1.25b of debt in September 2020, down from NT$1.56b, one year before. On the flip side, it has NT$368.9m in cash leading to net debt of about NT$883.1m.

A Look At Eagle Cold Storage Enterprise's Liabilities

According to the last reported balance sheet, Eagle Cold Storage Enterprise had liabilities of NT$1.55b due within 12 months, and liabilities of NT$127.0m due beyond 12 months. Offsetting this, it had NT$368.9m in cash and NT$406.7m in receivables that were due within 12 months. So it has liabilities totalling NT$896.7m more than its cash and near-term receivables, combined.

Eagle Cold Storage Enterprise has a market capitalization of NT$1.74b, so it could very likely raise cash to ameliorate 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). 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).

Eagle Cold Storage Enterprise has a rather high debt to EBITDA ratio of 8.7 which suggests a meaningful debt load. However, its interest coverage of 3.9 is reasonably strong, which is a good sign. Worse, Eagle Cold Storage Enterprise's EBIT was down 72% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Eagle Cold Storage Enterprise 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Eagle Cold Storage Enterprise burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

To be frank both Eagle Cold Storage Enterprise's conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. Having said that, its ability to handle its total liabilities isn't such a worry. We're quite clear that we consider Eagle Cold Storage Enterprise to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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. Take risks, for example - Eagle Cold Storage Enterprise has 4 warning signs (and 1 which shouldn't be ignored) we think 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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