These 4 Measures Indicate That China Metal Products (TPE:1532) Is Using Debt Extensively

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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 note that China Metal Products Co., Ltd. (TPE:1532) does have debt on its balance sheet. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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. If things get really bad, the lenders can take control of the business. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for China Metal Products

What Is China Metal Products's Debt?

As you can see below, China Metal Products had NT$19.0b of debt, at December 2020, which is about the same as the year before. You can click the chart for greater detail. However, because it has a cash reserve of NT$4.80b, its net debt is less, at about NT$14.2b.

How Healthy Is China Metal Products' Balance Sheet?

The latest balance sheet data shows that China Metal Products had liabilities of NT$15.1b due within a year, and liabilities of NT$13.7b falling due after that. Offsetting this, it had NT$4.80b in cash and NT$3.91b in receivables that were due within 12 months. So it has liabilities totalling NT$20.1b more than its cash and near-term receivables, combined.

When you consider that this deficiency exceeds the company's NT$14.0b market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive 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). 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).

With a net debt to EBITDA ratio of 7.0, it's fair to say China Metal Products does have a significant amount of debt. But the good news is that it boasts fairly comforting interest cover of 6.5 times, suggesting it can responsibly service its obligations. Also relevant is that China Metal Products has grown its EBIT by a very respectable 26% in the last year, thus enhancing its ability to pay down debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine China Metal Products's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

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. Over the most recent three years, China Metal Products recorded free cash flow worth 57% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

While China Metal Products's level of total liabilities makes us cautious about it, its track record of managing its debt, based on its EBITDA, is no better. But at least its EBIT growth rate is a gleaming silver lining to those clouds. When we consider all the factors discussed, it seems to us that China Metal Products is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. We've identified 3 warning signs with China Metal Products (at least 2 which don't sit too well with us) , and understanding them should be part of your investment process.

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.

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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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