These 4 Measures Indicate That Pan Asia Chemical (GTSM:4707) Is Using Debt Reasonably Well

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.' 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. Importantly, Pan Asia Chemical Corporation (GTSM:4707) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Pan Asia Chemical

What Is Pan Asia Chemical's Debt?

The chart below, which you can click on for greater detail, shows that Pan Asia Chemical had NT$2.68b in debt in September 2020; about the same as the year before. However, it also had NT$632.6m in cash, and so its net debt is NT$2.04b.

How Strong Is Pan Asia Chemical's Balance Sheet?

According to the last reported balance sheet, Pan Asia Chemical had liabilities of NT$2.16b due within 12 months, and liabilities of NT$840.6m due beyond 12 months. On the other hand, it had cash of NT$632.6m and NT$195.8m worth of receivables due within a year. So it has liabilities totalling NT$2.17b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of NT$3.31b, so it does suggest shareholders should keep an eye on Pan Asia Chemical's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Weak interest cover of 1.6 times and a disturbingly high net debt to EBITDA ratio of 17.4 hit our confidence in Pan Asia Chemical like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. However, it should be some comfort for shareholders to recall that Pan Asia Chemical actually grew its EBIT by a hefty 243%, over the last 12 months. If that earnings trend continues it will make its debt load much more manageable in the future. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Pan Asia Chemical's earnings that will influence how the balance sheet holds up in the future. 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Happily for any shareholders, Pan Asia Chemical actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

We weren't impressed with Pan Asia Chemical's interest cover, and its net debt to EBITDA made us cautious. But its conversion of EBIT to free cash flow was significantly redeeming. Looking at all this data makes us feel a little cautious about Pan Asia Chemical's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Consider for instance, the ever-present spectre of investment risk. We've identified 1 warning sign with Pan Asia Chemical , and understanding them should be part of your investment process.

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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