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. We note that Hsin Kuang Steel Company Limited (TPE:2031) does have debt on its balance sheet. But is this debt a concern to shareholders?
When Is Debt Dangerous?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Hsin Kuang Steel's Debt?
You can click the graphic below for the historical numbers, but it shows that as of December 2020 Hsin Kuang Steel had NT$10.5b of debt, an increase on NT$8.59b, over one year. However, it also had NT$2.75b in cash, and so its net debt is NT$7.72b.
A Look At Hsin Kuang Steel's Liabilities
We can see from the most recent balance sheet that Hsin Kuang Steel had liabilities of NT$7.27b falling due within a year, and liabilities of NT$4.52b due beyond that. Offsetting this, it had NT$2.75b in cash and NT$3.42b in receivables that were due within 12 months. So its liabilities total NT$5.63b more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since Hsin Kuang Steel has a market capitalization of NT$12.0b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
With a net debt to EBITDA ratio of 12.2, it's fair to say Hsin Kuang Steel does have a significant amount of debt. However, its interest coverage of 3.7 is reasonably strong, which is a good sign. One redeeming factor for Hsin Kuang Steel is that it turned last year's EBIT loss into a gain of NT$470m, over the last twelve months. 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 Hsin Kuang Steel'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, a company can only pay off debt with cold hard cash, not accounting profits. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. During the last year, Hsin Kuang Steel burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
On the face of it, Hsin Kuang Steel's net debt to EBITDA left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. Having said that, its ability to grow its EBIT isn't such a worry. Looking at the bigger picture, it seems clear to us that Hsin Kuang Steel's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. 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. For instance, we've identified 2 warning signs for Hsin Kuang Steel (1 shouldn't be ignored) you should be aware of.
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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