Is Song Ho Industrial (GTSM:5016) A Risky Investment?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Song Ho Industrial Co., Ltd. (GTSM:5016) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Song Ho Industrial

What Is Song Ho Industrial's Debt?

You can click the graphic below for the historical numbers, but it shows that Song Ho Industrial had NT$882.6m of debt in September 2020, down from NT$975.0m, one year before. On the flip side, it has NT$457.5m in cash leading to net debt of about NT$425.1m.

How Healthy Is Song Ho Industrial's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Song Ho Industrial had liabilities of NT$679.3m due within 12 months and liabilities of NT$684.4m due beyond that. Offsetting this, it had NT$457.5m in cash and NT$491.9m in receivables that were due within 12 months. So it has liabilities totalling NT$414.4m more than its cash and near-term receivables, combined.

This deficit isn't so bad because Song Ho Industrial is worth NT$1.60b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

We'd say that Song Ho Industrial's moderate net debt to EBITDA ratio ( being 1.6), indicates prudence when it comes to debt. And its strong interest cover of 23.7 times, makes us even more comfortable. In addition to that, we're happy to report that Song Ho Industrial has boosted its EBIT by 71%, thus reducing the spectre of future debt repayments. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Song Ho 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 it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Song Ho Industrial recorded free cash flow worth a fulsome 94% 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

Song Ho Industrial's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And the good news does not stop there, as its conversion of EBIT to free cash flow also supports that impression! Looking at the bigger picture, we think Song Ho Industrial's use of debt seems quite reasonable and we're not concerned about it. After all, sensible leverage can boost returns on equity. 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. Take risks, for example - Song Ho Industrial has 4 warning signs (and 1 which is significant) we think 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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This article by Simply Wall St is general in nature. 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.
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