Is Charoen Pokphand Enterprise(Taiwan) (TPE:1215) Using Too Much Debt?

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, Charoen Pokphand Enterprise(Taiwan) Co., Ltd. (TPE:1215) does carry debt. But the more important question is: how much risk is that debt creating?

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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Charoen Pokphand Enterprise(Taiwan)

What Is Charoen Pokphand Enterprise(Taiwan)'s Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Charoen Pokphand Enterprise(Taiwan) had NT$8.45b of debt, an increase on NT$7.41b, over one year. However, it also had NT$331.3m in cash, and so its net debt is NT$8.12b.

How Strong Is Charoen Pokphand Enterprise(Taiwan)'s Balance Sheet?

We can see from the most recent balance sheet that Charoen Pokphand Enterprise(Taiwan) had liabilities of NT$7.39b falling due within a year, and liabilities of NT$3.46b due beyond that. On the other hand, it had cash of NT$331.3m and NT$2.31b worth of receivables due within a year. So its liabilities total NT$8.21b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Charoen Pokphand Enterprise(Taiwan) has a market capitalization of NT$18.9b, and so it could probably strengthen its balance sheet by raising capital if it needed to. 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).

Charoen Pokphand Enterprise(Taiwan)'s net debt is 3.5 times its EBITDA, which is a significant but still reasonable amount of leverage. However, its interest coverage of 23.0 is very high, suggesting that the interest expense on the debt is currently quite low. We saw Charoen Pokphand Enterprise(Taiwan) grow its EBIT by 2.1% in the last twelve months. That's far from incredible but it is a good thing, when it comes to paying off debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Charoen Pokphand Enterprise(Taiwan)'s ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

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. Over the last three years, Charoen Pokphand Enterprise(Taiwan) saw substantial negative free cash flow, in total. 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

Neither Charoen Pokphand Enterprise(Taiwan)'s ability to convert EBIT to free cash flow nor its net debt to EBITDA gave us confidence in its ability to take on more debt. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. When we consider all the factors discussed, it seems to us that Charoen Pokphand Enterprise(Taiwan) is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Consider for instance, the ever-present spectre of investment risk. We've identified 3 warning signs with Charoen Pokphand Enterprise(Taiwan) (at least 1 which makes us a bit uncomfortable) , and understanding them should be part of your investment process.

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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