Is Formosa Chemicals & Fibre (TPE:1326) A Risky Investment?

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.' 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. We can see that Formosa Chemicals & Fibre Corporation (TPE:1326) does use debt in its business. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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 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 Formosa Chemicals & Fibre

What Is Formosa Chemicals & Fibre's Net Debt?

The image below, which you can click on for greater detail, shows that Formosa Chemicals & Fibre had debt of NT$94.1b at the end of December 2020, a reduction from NT$99.7b over a year. But on the other hand it also has NT$131.6b in cash, leading to a NT$37.5b net cash position.

A Look At Formosa Chemicals & Fibre's Liabilities

The latest balance sheet data shows that Formosa Chemicals & Fibre had liabilities of NT$73.5b due within a year, and liabilities of NT$62.9b falling due after that. On the other hand, it had cash of NT$131.6b and NT$40.3b worth of receivables due within a year. So it actually has NT$35.5b more liquid assets than total liabilities.

This short term liquidity is a sign that Formosa Chemicals & Fibre could probably pay off its debt with ease, as its balance sheet is far from stretched. Succinctly put, Formosa Chemicals & Fibre boasts net cash, so it's fair to say it does not have a heavy debt load!

But the other side of the story is that Formosa Chemicals & Fibre saw its EBIT decline by 6.4% over the last year. That sort of decline, if sustained, will obviously make debt harder to handle. 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 Formosa Chemicals & Fibre can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. While Formosa Chemicals & Fibre 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. Over the last three years, Formosa Chemicals & Fibre actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that Formosa Chemicals & Fibre has net cash of NT$37.5b, as well as more liquid assets than liabilities. And it impressed us with free cash flow of NT$31b, being 168% of its EBIT. So we don't think Formosa Chemicals & Fibre's use of debt is risky. 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. For instance, we've identified 1 warning sign for Formosa Chemicals & Fibre that you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

If you’re looking to trade Formosa Chemicals & Fibre, open an account with the lowest-cost* platform trusted by professionals, Interactive Brokers. Their clients from over 200 countries and territories trade stocks, options, futures, forex, bonds and funds worldwide from a single integrated account. Promoted

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.
^*Interactive Brokers Rated Lowest Cost Broker by StockBrokers.com Annual Online Review 2020

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.