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. We can see that Yem Chio Co., Ltd. (TPE:4306) does use debt in its business. But should shareholders be worried about its use of debt?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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.

View our latest analysis for Yem Chio

What Is Yem Chio's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Yem Chio had NT$16.4b of debt in December 2020, down from NT$20.2b, one year before. However, it also had NT$2.46b in cash, and so its net debt is NT$13.9b.

A Look At Yem Chio's Liabilities

Zooming in on the latest balance sheet data, we can see that Yem Chio had liabilities of NT$13.3b due within 12 months and liabilities of NT$6.53b due beyond that. Offsetting this, it had NT$2.46b in cash and NT$2.92b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$14.5b.

When you consider that this deficiency exceeds the company's NT$9.67b 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).

Yem Chio has a rather high debt to EBITDA ratio of 10.2 which suggests a meaningful debt load. However, its interest coverage of 3.8 is reasonably strong, which is a good sign. However, it should be some comfort for shareholders to recall that Yem Chio actually grew its EBIT by a hefty 214%, over the last 12 months. If that earnings trend continues it will make its debt load much more manageable in the future. 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 Yem Chio 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, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Yem Chio actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

We feel some trepidation about Yem Chio's difficulty net debt to EBITDA, but we've got positives to focus on, too. 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. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 5 warning signs for Yem Chio (2 don't sit too well with us) you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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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