Does Hai Kwang Enterprise (TPE:2038) Have A Healthy Balance Sheet?

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. Importantly, Hai Kwang Enterprise Corporation (TPE:2038) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Hai Kwang Enterprise

How Much Debt Does Hai Kwang Enterprise Carry?

You can click the graphic below for the historical numbers, but it shows that as of December 2020 Hai Kwang Enterprise had NT$3.46b of debt, an increase on NT$3.25b, over one year. On the flip side, it has NT$215.5m in cash leading to net debt of about NT$3.25b.

How Healthy Is Hai Kwang Enterprise's Balance Sheet?

According to the last reported balance sheet, Hai Kwang Enterprise had liabilities of NT$3.17b due within 12 months, and liabilities of NT$1.60b due beyond 12 months. On the other hand, it had cash of NT$215.5m and NT$710.9m worth of receivables due within a year. So it has liabilities totalling NT$3.84b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of NT$3.30b, we think shareholders really should watch Hai Kwang Enterprise's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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). 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).

Hai Kwang Enterprise has a rather high debt to EBITDA ratio of 8.5 which suggests a meaningful debt load. However, its interest coverage of 3.6 is reasonably strong, which is a good sign. One redeeming factor for Hai Kwang Enterprise is that it turned last year's EBIT loss into a gain of NT$179m, over the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Hai Kwang Enterprise 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, Hai Kwang Enterprise 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.

Our View

To be frank both Hai Kwang Enterprise's net debt to EBITDA and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. Having said that, its ability to grow its EBIT isn't such a worry. Taking into account all the aforementioned factors, it looks like Hai Kwang Enterprise has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. 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. To that end, you should learn about the 2 warning signs we've spotted with Hai Kwang Enterprise (including 1 which shouldn't be ignored) .

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.

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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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