These 4 Measures Indicate That Chain Chon Industrial (GTSM:5014) Is Using Debt Extensively

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.' 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. Importantly, Chain Chon Industrial Co., Ltd. (GTSM:5014) does carry debt. But the real question is whether this debt is making the company risky.

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. 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, 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Chain Chon Industrial

What Is Chain Chon Industrial's Net Debt?

As you can see below, at the end of September 2020, Chain Chon Industrial had NT$3.27b of debt, up from NT$2.98b a year ago. Click the image for more detail. However, because it has a cash reserve of NT$481.4m, its net debt is less, at about NT$2.79b.

How Strong Is Chain Chon Industrial's Balance Sheet?

We can see from the most recent balance sheet that Chain Chon Industrial had liabilities of NT$4.58b falling due within a year, and liabilities of NT$189.4m due beyond that. On the other hand, it had cash of NT$481.4m and NT$1.63b worth of receivables due within a year. So its liabilities total NT$2.65b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of NT$2.81b, so it does suggest shareholders should keep an eye on Chain Chon Industrial's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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.

Chain Chon Industrial shareholders face the double whammy of a high net debt to EBITDA ratio (11.1), and fairly weak interest coverage, since EBIT is just 1.2 times the interest expense. This means we'd consider it to have a heavy debt load. However, one redeeming factor is that Chain Chon Industrial grew its EBIT at 12% over the last 12 months, boosting its ability to handle its debt. 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 Chain Chon Industrial 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Chain Chon Industrial recorded free cash flow worth a fulsome 95% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Our View

Chain Chon Industrial's interest cover and net debt to EBITDA definitely weigh on it, in our esteem. But the good news is it seems to be able to convert EBIT to free cash flow with ease. Taking the abovementioned factors together we do think Chain Chon Industrial's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. Be aware that Chain Chon Industrial is showing 3 warning signs in our investment analysis , and 1 of those makes us a bit uncomfortable...

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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