Here's Why Lian Hwa Foods (TWSE:1231) Has A Meaningful Debt Burden

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.' 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. Importantly, Lian Hwa Foods Corporation (TWSE:1231) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Lian Hwa Foods

What Is Lian Hwa Foods's Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2024 Lian Hwa Foods had NT$5.48b of debt, an increase on NT$4.36b, over one year. However, because it has a cash reserve of NT$907.8m, its net debt is less, at about NT$4.58b.

How Healthy Is Lian Hwa Foods' Balance Sheet?

The latest balance sheet data shows that Lian Hwa Foods had liabilities of NT$4.02b due within a year, and liabilities of NT$3.75b falling due after that. Offsetting this, it had NT$907.8m in cash and NT$2.51b in receivables that were due within 12 months. So its liabilities total NT$4.35b more than the combination of its cash and short-term receivables.

Given Lian Hwa Foods has a market capitalization of NT$47.8b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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 3.8 times its EBITDA, which is a significant but still reasonable amount of leverage. But its EBIT was about 18.7 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. Sadly, Lian Hwa Foods's EBIT actually dropped 10.0% 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 you can't view debt in total isolation; since Lian Hwa Foods will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Lian Hwa Foods burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Lian Hwa Foods's conversion of EBIT to free cash flow and EBIT growth rate 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. When we consider all the factors discussed, it seems to us that Lian Hwa Foods 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. However, not all investment risk resides within the balance sheet - far from it. Be aware that Lian Hwa Foods is showing 2 warning signs in our investment analysis , you should know about...

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.