Shinkong Synthetic Fibers (TPE:1409) Takes On Some Risk With Its Use Of Debt

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. Importantly, Shinkong Synthetic Fibers Corporation (TPE:1409) does carry debt. But the more important question is: how much risk is that debt creating?

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. 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. 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.

View our latest analysis for Shinkong Synthetic Fibers

What Is Shinkong Synthetic Fibers's Net Debt?

The image below, which you can click on for greater detail, shows that at December 2020 Shinkong Synthetic Fibers had debt of NT$43.1b, up from NT$35.4b in one year. However, it also had NT$22.5b in cash, and so its net debt is NT$20.6b.

How Healthy Is Shinkong Synthetic Fibers' Balance Sheet?

The latest balance sheet data shows that Shinkong Synthetic Fibers had liabilities of NT$114.2b due within a year, and liabilities of NT$17.5b falling due after that. Offsetting this, it had NT$22.5b in cash and NT$84.6b in receivables that were due within 12 months. So its liabilities total NT$24.7b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of NT$29.5b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe 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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Shinkong Synthetic Fibers's debt is 3.3 times its EBITDA, and its EBIT cover its interest expense 5.7 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. If Shinkong Synthetic Fibers can keep growing EBIT at last year's rate of 14% over the last year, then it will find its debt load easier to manage. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Shinkong Synthetic Fibers's earnings that will influence how the balance sheet holds up in the future. 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Shinkong Synthetic Fibers reported free cash flow worth 8.8% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

On the face of it, Shinkong Synthetic Fibers's level of total liabilities left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Once we consider all the factors above, together, it seems to us that Shinkong Synthetic Fibers's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 5 warning signs for Shinkong Synthetic Fibers (of which 1 doesn't sit too well with us!) you should know about.

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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