Is Luo Lih-Fen Holding (TPE:6666) A Risky Investment?

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.' 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, Luo Lih-Fen Holding Co., Ltd. (TPE:6666) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Luo Lih-Fen Holding

What Is Luo Lih-Fen Holding's Net Debt?

The image below, which you can click on for greater detail, shows that at December 2020 Luo Lih-Fen Holding had debt of NT$92.2m, up from none in one year. However, it does have NT$1.22b in cash offsetting this, leading to net cash of NT$1.13b.

How Strong Is Luo Lih-Fen Holding's Balance Sheet?

According to the last reported balance sheet, Luo Lih-Fen Holding had liabilities of NT$332.2m due within 12 months, and liabilities of NT$103.7m due beyond 12 months. On the other hand, it had cash of NT$1.22b and NT$31.2m worth of receivables due within a year. So it can boast NT$818.3m more liquid assets than total liabilities.

It's good to see that Luo Lih-Fen Holding has plenty of liquidity on its balance sheet, suggesting conservative management of liabilities. Given it has easily adequate short term liquidity, we don't think it will have any issues with its lenders. Succinctly put, Luo Lih-Fen Holding boasts net cash, so it's fair to say it does not have a heavy debt load!

The modesty of its debt load may become crucial for Luo Lih-Fen Holding if management cannot prevent a repeat of the 89% cut to EBIT over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Luo Lih-Fen Holding 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. Luo Lih-Fen Holding may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Looking at the most recent three years, Luo Lih-Fen Holding recorded free cash flow of 21% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that Luo Lih-Fen Holding has net cash of NT$1.13b, as well as more liquid assets than liabilities. So we don't have any problem with Luo Lih-Fen Holding's use of debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should learn about the 3 warning signs we've spotted with Luo Lih-Fen Holding (including 1 which is significant) .

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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