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 Chun Yuan Steel Industry Co., Ltd. (TPE:2010) makes use of debt. But should shareholders be worried about its use of debt?
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. 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.
What Is Chun Yuan Steel Industry’s Debt?
As you can see below, Chun Yuan Steel Industry had NT$4.50b of debt, at September 2019, which is about the same the year before. You can click the chart for greater detail. However, it also had NT$1.16b in cash, and so its net debt is NT$3.34b.
How Strong Is Chun Yuan Steel Industry’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Chun Yuan Steel Industry had liabilities of NT$6.20b due within 12 months and liabilities of NT$985.1m due beyond that. Offsetting this, it had NT$1.16b in cash and NT$6.75b in receivables that were due within 12 months. So it can boast NT$721.3m more liquid assets than total liabilities.
This surplus suggests that Chun Yuan Steel Industry has a conservative balance sheet, and could probably eliminate its debt without much difficulty.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
With a net debt to EBITDA ratio of 8.5, it’s fair to say Chun Yuan Steel Industry does have a significant amount of debt. However, its interest coverage of 4.7 is reasonably strong, which is a good sign. Importantly, Chun Yuan Steel Industry’s EBIT fell a jaw-dropping 53% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. There’s no doubt that we learn most about debt from the balance sheet. But you can’t view debt in total isolation; since Chun Yuan Steel Industry will need earnings to service that debt. So when considering debt, it’s definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it’s worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Chun Yuan Steel Industry saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.
To be frank both Chun Yuan Steel Industry’s conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But on the bright side, its level of total liabilities is a good sign, and makes us more optimistic. Overall, we think it’s fair to say that Chun Yuan Steel Industry has enough debt that there are some real risks around the balance sheet. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. Another positive for shareholders is that it pays dividends. So if you like receiving those dividend payments, check Chun Yuan Steel Industry’s dividend history, without delay!
When all is said and done, sometimes its easier to focus on companies that don’t even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
If you spot an error that warrants correction, please contact the editor at email@example.com. 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. Simply Wall St has no position in the stocks mentioned.
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