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. Importantly, Yuen Chang Stainless Steel Co., Ltd. (TPE:2069) does carry debt. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. When we think about a company's use of debt, we first look at cash and debt together.
What Is Yuen Chang Stainless Steel's Net Debt?
The chart below, which you can click on for greater detail, shows that Yuen Chang Stainless Steel had NT$4.39b in debt in September 2020; about the same as the year before. On the flip side, it has NT$479.5m in cash leading to net debt of about NT$3.91b.
How Healthy Is Yuen Chang Stainless Steel's Balance Sheet?
The latest balance sheet data shows that Yuen Chang Stainless Steel had liabilities of NT$3.60b due within a year, and liabilities of NT$1.34b falling due after that. Offsetting these obligations, it had cash of NT$479.5m as well as receivables valued at NT$791.8m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$3.67b.
When you consider that this deficiency exceeds the company's NT$2.60b market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (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).
Yuen Chang Stainless Steel shareholders face the double whammy of a high net debt to EBITDA ratio (13.7), and fairly weak interest coverage, since EBIT is just 0.64 times the interest expense. The debt burden here is substantial. One redeeming factor for Yuen Chang Stainless Steel is that it turned last year's EBIT loss into a gain of NT$83m, over the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Yuen Chang Stainless Steel will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the most recent year, Yuen Chang Stainless Steel recorded free cash flow worth 71% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
To be frank both Yuen Chang Stainless Steel's net debt to EBITDA and its track record of covering its interest expense with its EBIT make us rather uncomfortable with its debt levels. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Overall, we think it's fair to say that Yuen Chang Stainless Steel has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. The balance sheet is clearly the area to focus on when you are analysing debt. 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 3 warning signs with Yuen Chang Stainless Steel (at least 1 which makes us a bit uncomfortable) , and understanding them should be part of your investment process.
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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