Here's Why Evergreen Steel (GTSM:2211) Can Manage Its Debt Responsibly

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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. We can see that Evergreen Steel Corp. (GTSM:2211) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt A Problem?

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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Evergreen Steel

What Is Evergreen Steel's Debt?

As you can see below, at the end of September 2020, Evergreen Steel had NT$4.01b of debt, up from NT$952.3m a year ago. Click the image for more detail. However, it does have NT$4.02b in cash offsetting this, leading to net cash of NT$6.51m.

How Healthy Is Evergreen Steel's Balance Sheet?

We can see from the most recent balance sheet that Evergreen Steel had liabilities of NT$5.51b falling due within a year, and liabilities of NT$1.32b due beyond that. On the other hand, it had cash of NT$4.02b and NT$5.08b worth of receivables due within a year. So it actually has NT$2.27b more liquid assets than total liabilities.

This short term liquidity is a sign that Evergreen Steel could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Evergreen Steel has more cash than debt is arguably a good indication that it can manage its debt safely.

The good news is that Evergreen Steel has increased its EBIT by 7.7% over twelve months, which should ease any concerns about debt repayment. 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 Evergreen Steel 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. While Evergreen Steel has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. In the last three years, Evergreen Steel created free cash flow amounting to 12% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that Evergreen Steel has net cash of NT$6.51m, as well as more liquid assets than liabilities. On top of that, it increased its EBIT by 7.7% in the last twelve months. So we are not troubled with Evergreen Steel's debt use. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Evergreen Steel (of which 1 is concerning!) you should know about.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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