Is Namchow Holdings (TPE:1702) A Risky Investment?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Namchow Holdings Co., Ltd. (TPE:1702) does use debt in its business. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Namchow Holdings

What Is Namchow Holdings's Debt?

The image below, which you can click on for greater detail, shows that at September 2020 Namchow Holdings had debt of NT$12.5b, up from NT$12.0b in one year. However, because it has a cash reserve of NT$5.34b, its net debt is less, at about NT$7.15b.

A Look At Namchow Holdings' Liabilities

According to the last reported balance sheet, Namchow Holdings had liabilities of NT$8.10b due within 12 months, and liabilities of NT$10.1b due beyond 12 months. Offsetting this, it had NT$5.34b in cash and NT$2.14b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$10.7b.

This deficit is considerable relative to its market capitalization of NT$11.3b, so it does suggest shareholders should keep an eye on Namchow Holdings' use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

With net debt to EBITDA of 3.0 Namchow Holdings has a fairly noticeable amount of debt. But the high interest coverage of 9.4 suggests it can easily service that debt. Sadly, Namchow Holdings's EBIT actually dropped 4.0% in the last year. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Namchow Holdings can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Namchow Holdings's free cash flow amounted to 44% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

On this analysis Namchow Holdings's level of total liabilities was a real concern. But to the contrary its interest cover is quite lulling. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Namchow Holdings stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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. For instance, we've identified 3 warning signs for Namchow Holdings (2 are a bit concerning) you should be aware of.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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