We Think Wei Chuan Foods (TPE:1201) Is Taking Some Risk With Its Debt

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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. As with many other companies Wei Chuan Foods Corporation (TPE:1201) makes use of debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Wei Chuan Foods

What Is Wei Chuan Foods's Net Debt?

The image below, which you can click on for greater detail, shows that Wei Chuan Foods had debt of NT$6.35b at the end of September 2020, a reduction from NT$7.04b over a year. However, it does have NT$1.77b in cash offsetting this, leading to net debt of about NT$4.58b.

A Look At Wei Chuan Foods's Liabilities

We can see from the most recent balance sheet that Wei Chuan Foods had liabilities of NT$7.61b falling due within a year, and liabilities of NT$4.45b due beyond that. Offsetting this, it had NT$1.77b in cash and NT$3.07b in receivables that were due within 12 months. So its liabilities total NT$7.21b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of NT$10.5b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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

Wei Chuan Foods's debt is 3.2 times its EBITDA, and its EBIT cover its interest expense 4.0 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. More concerning, Wei Chuan Foods saw its EBIT drop by 3.8% in the last twelve months. If that earnings trend continues the company will face an uphill battle to pay off its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is Wei Chuan Foods'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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Wei Chuan Foods's free cash flow amounted to 43% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

At the end of the day, we're far from enamoured with Wei Chuan Foods's ability to handle its total liabilities or handle its debt, based on its EBITDA,. But its conversion of EBIT to free cash flow is a slight positive. Once we consider all the factors above, together, it seems to us that Wei Chuan Foods's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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. Be aware that Wei Chuan Foods is showing 3 warning signs in our investment analysis , you should know about...

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. 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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