Here's Why Formosa Oilseed Processing (TPE:1225) Has A Meaningful Debt Burden

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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 Formosa Oilseed Processing Co., Ltd. (TPE:1225) makes use of debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Formosa Oilseed Processing

How Much Debt Does Formosa Oilseed Processing Carry?

As you can see below, Formosa Oilseed Processing had NT$3.17b of debt at September 2020, down from NT$3.70b a year prior. However, it does have NT$1.15b in cash offsetting this, leading to net debt of about NT$2.02b.

How Healthy Is Formosa Oilseed Processing's Balance Sheet?

According to the last reported balance sheet, Formosa Oilseed Processing had liabilities of NT$3.09b due within 12 months, and liabilities of NT$786.5m due beyond 12 months. Offsetting this, it had NT$1.15b in cash and NT$1.63b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$1.10b.

Since publicly traded Formosa Oilseed Processing shares are worth a total of NT$9.45b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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). 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).

Formosa Oilseed Processing has a debt to EBITDA ratio of 4.0, which signals significant debt, but is still pretty reasonable for most types of business. But its EBIT was about 22.7 times its interest expense, implying the company isn't really paying a high cost to maintain that level of debt. Even were the low cost to prove unsustainable, that is a good sign. Unfortunately, Formosa Oilseed Processing saw its EBIT slide 4.4% in the last twelve months. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. When analysing debt levels, the balance sheet is the obvious place to start. But it is Formosa Oilseed Processing's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

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, Formosa Oilseed Processing barely recorded positive free cash flow, in total. While many companies do operate at break-even, we prefer see substantial free cash flow, especially if a it already has dead.

Our View

Formosa Oilseed Processing's conversion of EBIT to free cash flow and net debt to EBITDA definitely weigh on it, in our esteem. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. Looking at all the angles mentioned above, it does seem to us that Formosa Oilseed Processing is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. 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. We've identified 4 warning signs with Formosa Oilseed Processing (at least 2 which are potentially serious) , 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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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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