Is Formosa Oilseed Processing (TWSE:1225) Using Too Much Debt?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Formosa Oilseed Processing Co., Ltd. (TWSE:1225) does use debt in its business. But the real question is whether this debt is making the company risky.

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. 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 Formosa Oilseed Processing

How Much Debt Does Formosa Oilseed Processing Carry?

You can click the graphic below for the historical numbers, but it shows that as of September 2024 Formosa Oilseed Processing had NT$3.95b of debt, an increase on NT$3.37b, over one year. However, because it has a cash reserve of NT$1.41b, its net debt is less, at about NT$2.54b.

How Strong Is Formosa Oilseed Processing's Balance Sheet?

We can see from the most recent balance sheet that Formosa Oilseed Processing had liabilities of NT$3.58b falling due within a year, and liabilities of NT$1.21b due beyond that. Offsetting these obligations, it had cash of NT$1.41b as well as receivables valued at NT$1.70b due within 12 months. So its liabilities total NT$1.68b more than the combination of its cash and short-term receivables.

Since publicly traded Formosa Oilseed Processing shares are worth a total of NT$8.88b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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

Formosa Oilseed Processing has net debt to EBITDA of 3.9 suggesting it uses a fair bit of leverage to boost returns. But the high interest coverage of 7.5 suggests it can easily service that debt. Importantly, Formosa Oilseed Processing grew its EBIT by 80% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Formosa Oilseed Processing 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Formosa Oilseed Processing generated free cash flow amounting to a very robust 82% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Our View

Happily, Formosa Oilseed Processing's impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. But, on a more sombre note, we are a little concerned by its net debt to EBITDA. Looking at the bigger picture, we think Formosa Oilseed Processing's use of debt seems quite reasonable and we're not concerned about it. After all, sensible leverage can boost returns on equity. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 4 warning signs for Formosa Oilseed Processing (3 are significant!) that you should be aware of before investing here.

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. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.