We Think China Man-Made Fiber (TPE:1718) Is Taking Some Risk With Its Debt

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. As with many other companies China Man-Made Fiber Corporation (TPE:1718) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for China Man-Made Fiber

What Is China Man-Made Fiber's Debt?

As you can see below, China Man-Made Fiber had NT$45.5b of debt at September 2020, down from NT$48.4b a year prior. However, because it has a cash reserve of NT$38.5b, its net debt is less, at about NT$7.02b.

How Strong Is China Man-Made Fiber's Balance Sheet?

The latest balance sheet data shows that China Man-Made Fiber had liabilities of NT$659.2b due within a year, and liabilities of NT$18.4b falling due after that. Offsetting these obligations, it had cash of NT$38.5b as well as receivables valued at NT$476.6b due within 12 months. So its liabilities total NT$162.6b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the NT$11.1b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, China Man-Made Fiber would likely require a major re-capitalisation if it had to pay its creditors today.

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). 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).

Given net debt is only 0.84 times EBITDA, it is initially surprising to see that China Man-Made Fiber's EBIT has low interest coverage of 1.7 times. So while we're not necessarily alarmed we think that its debt is far from trivial. Sadly, China Man-Made Fiber's EBIT actually dropped 7.9% in the last year. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since China Man-Made Fiber will need earnings to service that debt. 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 we always check how much of that EBIT is translated into free cash flow. Over the last three years, China Man-Made Fiber actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

On the face of it, China Man-Made Fiber's interest cover left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Overall, we think it's fair to say that China Man-Made Fiber has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Be aware that China Man-Made Fiber is showing 4 warning signs in our investment analysis , and 2 of those are potentially serious...

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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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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