Yuen Chang Stainless Steel (TPE:2069) Seems To Be Using A Lot Of Debt

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that Yuen Chang Stainless Steel Co., Ltd. (TPE:2069) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Yuen Chang Stainless Steel

What Is Yuen Chang Stainless Steel's Debt?

The image below, which you can click on for greater detail, shows that at December 2020 Yuen Chang Stainless Steel had debt of NT$4.63b, up from NT$4.19b in one year. However, it also had NT$523.1m in cash, and so its net debt is NT$4.11b.

How Healthy Is Yuen Chang Stainless Steel's Balance Sheet?

According to the last reported balance sheet, Yuen Chang Stainless Steel had liabilities of NT$3.82b due within 12 months, and liabilities of NT$1.33b due beyond 12 months. On the other hand, it had cash of NT$523.1m and NT$992.7m worth of receivables due within a year. So its liabilities total NT$3.64b more than the combination of its cash and short-term receivables.

Given this deficit is actually higher than the company's market capitalization of NT$3.08b, we think shareholders really should watch Yuen Chang Stainless Steel's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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.

Weak interest cover of 0.93 times and a disturbingly high net debt to EBITDA ratio of 13.0 hit our confidence in Yuen Chang Stainless Steel like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. On a slightly more positive note, Yuen Chang Stainless Steel grew its EBIT at 14% over the last year, further increasing its ability to manage debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Yuen Chang Stainless Steel's earnings that will influence how the balance sheet holds up in the future. 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Yuen Chang Stainless Steel saw substantial negative free cash flow, in total. 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.

Our View

To be frank both Yuen Chang Stainless Steel's interest cover and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. We're quite clear that we consider Yuen Chang Stainless 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. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 3 warning signs for Yuen Chang Stainless Steel (2 don't sit too well with us!) that you should be aware of before investing here.

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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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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