These 4 Measures Indicate That Hsin Kuang Steel (TPE:2031) Is Using Debt Extensively

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 Hsin Kuang Steel Company Limited (TPE:2031) makes use of debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

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. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Hsin Kuang Steel

What Is Hsin Kuang Steel's Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Hsin Kuang Steel had NT$10.6b of debt, an increase on NT$8.91b, over one year. However, it also had NT$2.74b in cash, and so its net debt is NT$7.90b.

How Strong Is Hsin Kuang Steel's Balance Sheet?

The latest balance sheet data shows that Hsin Kuang Steel had liabilities of NT$8.21b due within a year, and liabilities of NT$3.52b falling due after that. Offsetting this, it had NT$2.74b in cash and NT$3.34b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$5.66b.

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.

Hsin Kuang Steel shareholders face the double whammy of a high net debt to EBITDA ratio (31.6), and fairly weak interest coverage, since EBIT is just 1.2 times the interest expense. This means we'd consider it to have a heavy debt load. One redeeming factor for Hsin Kuang Steel is that it turned last year's EBIT loss into a gain of NT$99m, over the last twelve months. There's no doubt that we learn most about debt from the balance sheet. 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. During the last year, Hsin Kuang Steel burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

On the face of it, Hsin Kuang Steel's interest cover 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. But at least its EBIT growth rate is not so bad. We're quite clear that we consider Hsin Kuang Steel to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. Case in point: We've spotted 1 warning sign for Hsin Kuang Steel you should be aware of.

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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