Here's Why Tung Ho Steel Enterprise (TPE:2006) Can Manage Its Debt Responsibly

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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Tung Ho Steel Enterprise Corporation (TPE:2006) 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. If things get really bad, the lenders can take control of the business. 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.

View our latest analysis for Tung Ho Steel Enterprise

What Is Tung Ho Steel Enterprise's Debt?

As you can see below, Tung Ho Steel Enterprise had NT$12.9b of debt at September 2020, down from NT$19.1b a year prior. However, because it has a cash reserve of NT$1.43b, its net debt is less, at about NT$11.4b.

How Healthy Is Tung Ho Steel Enterprise's Balance Sheet?

According to the last reported balance sheet, Tung Ho Steel Enterprise had liabilities of NT$16.0b due within 12 months, and liabilities of NT$3.38b due beyond 12 months. On the other hand, it had cash of NT$1.43b and NT$5.61b worth of receivables due within a year. So it has liabilities totalling NT$12.3b more than its cash and near-term receivables, combined.

Tung Ho Steel Enterprise has a market capitalization of NT$36.9b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Tung Ho Steel Enterprise's net debt to EBITDA ratio of about 2.3 suggests only moderate use of debt. And its strong interest cover of 17.7 times, makes us even more comfortable. Pleasingly, Tung Ho Steel Enterprise is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 110% gain in the last twelve months. 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 Tung Ho Steel Enterprise 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Tung Ho Steel Enterprise created free cash flow amounting to 18% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

Happily, Tung Ho Steel Enterprise's impressive interest cover implies it has the upper hand on its debt. But, on a more sombre note, we are a little concerned by its conversion of EBIT to free cash flow. Looking at all the aforementioned factors together, it strikes us that Tung Ho Steel Enterprise can handle its debt fairly comfortably. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Consider for instance, the ever-present spectre of investment risk. We've identified 2 warning signs with Tung Ho Steel Enterprise , and understanding them should be part of your investment process.

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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