These 4 Measures Indicate That Yem Chio (TPE:4306) 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.' 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, Yem Chio Co., Ltd. (TPE:4306) does carry debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Yem Chio

What Is Yem Chio's Net Debt?

As you can see below, Yem Chio had NT$17.7b of debt at September 2020, down from NT$21.0b a year prior. On the flip side, it has NT$3.39b in cash leading to net debt of about NT$14.3b.

How Strong Is Yem Chio's Balance Sheet?

We can see from the most recent balance sheet that Yem Chio had liabilities of NT$13.6b falling due within a year, and liabilities of NT$7.24b due beyond that. Offsetting this, it had NT$3.39b in cash and NT$2.60b in receivables that were due within 12 months. So it has liabilities totalling NT$14.8b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the NT$8.51b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Yem Chio would likely require a major re-capitalisation if it had to pay its creditors today.

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.

Yem Chio shareholders face the double whammy of a high net debt to EBITDA ratio (11.3), and fairly weak interest coverage, since EBIT is just 2.4 times the interest expense. This means we'd consider it to have a heavy debt load. The silver lining is that Yem Chio grew its EBIT by 253% last year, which nourishing like the idealism of youth. If that earnings trend continues it will make its debt load much more manageable in the future. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Yem Chio 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 we always check how much of that EBIT is translated into free cash flow. Happily for any shareholders, Yem Chio actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

While Yem Chio's level of total liabilities has us nervous. For example, its conversion of EBIT to free cash flow and EBIT growth rate give us some confidence in its ability to manage its debt. Taking the abovementioned factors together we do think Yem Chio's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. 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. To that end, you should learn about the 3 warning signs we've spotted with Yem Chio (including 2 which can't be ignored) .

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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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