Is Formosan Union Chemical (TPE:1709) A Risky Investment?

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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Formosan Union Chemical Corp. (TPE:1709) makes use of debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Formosan Union Chemical

What Is Formosan Union Chemical's Debt?

The image below, which you can click on for greater detail, shows that Formosan Union Chemical had debt of NT$2.05b at the end of September 2020, a reduction from NT$2.59b over a year. However, it also had NT$369.9m in cash, and so its net debt is NT$1.68b.

How Strong Is Formosan Union Chemical's Balance Sheet?

We can see from the most recent balance sheet that Formosan Union Chemical had liabilities of NT$2.90b falling due within a year, and liabilities of NT$769.9m due beyond that. Offsetting this, it had NT$369.9m in cash and NT$1.37b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$1.93b.

Formosan Union Chemical has a market capitalization of NT$6.75b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

We'd say that Formosan Union Chemical's moderate net debt to EBITDA ratio ( being 2.0), indicates prudence when it comes to debt. And its strong interest cover of 17.8 times, makes us even more comfortable. Notably, Formosan Union Chemical's EBIT launched higher than Elon Musk, gaining a whopping 169% on last year. There's no doubt that we learn most about debt from the balance sheet. But it is Formosan Union Chemical's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the most recent three years, Formosan Union Chemical recorded free cash flow worth 68% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

The good news is that Formosan Union Chemical's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And the good news does not stop there, as its EBIT growth rate also supports that impression! Zooming out, Formosan Union Chemical seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Formosan Union Chemical is showing 2 warning signs in our investment analysis , and 1 of those makes us a bit uncomfortable...

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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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