Lian Hwa Foods (TPE:1231) Seems To Use Debt Quite Sensibly

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.' 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, Lian Hwa Foods Corporation (TPE:1231) does carry debt. But the more important question is: how much risk is that debt creating?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Lian Hwa Foods

What Is Lian Hwa Foods's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Lian Hwa Foods had NT$3.23b of debt, an increase on NT$1.73b, over one year. On the flip side, it has NT$451.6m in cash leading to net debt of about NT$2.78b.

How Healthy Is Lian Hwa Foods' Balance Sheet?

The latest balance sheet data shows that Lian Hwa Foods had liabilities of NT$2.63b due within a year, and liabilities of NT$2.30b falling due after that. On the other hand, it had cash of NT$451.6m and NT$1.87b worth of receivables due within a year. So its liabilities total NT$2.60b more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Lian Hwa Foods is worth NT$8.44b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Lian Hwa Foods's net debt is 2.9 times its EBITDA, which is a significant but still reasonable amount of leverage. But its EBIT was about 26.8 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. It is well worth noting that Lian Hwa Foods's EBIT shot up like bamboo after rain, gaining 38% in the last twelve months. That'll make it easier to manage its debt. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Lian Hwa Foods will need earnings to service that debt. 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Considering the last three years, Lian Hwa Foods actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

Lian Hwa Foods's interest cover was a real positive on this analysis, as was its EBIT growth rate. But truth be told its conversion of EBIT to free cash flow had us nibbling our nails. When we consider all the factors mentioned above, we do feel a bit cautious about Lian Hwa Foods's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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. Consider for instance, the ever-present spectre of investment risk. We've identified 2 warning signs with Lian Hwa Foods , 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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