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. As with many other companies Jinan Acetate Chemical Co., Ltd. (TPE:4763) makes use of debt. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Jinan Acetate Chemical Carry?
The image below, which you can click on for greater detail, shows that at September 2020 Jinan Acetate Chemical had debt of NT$1.01b, up from NT$583.9m in one year. However, it does have NT$1.02b in cash offsetting this, leading to net cash of NT$11.9m.
How Healthy Is Jinan Acetate Chemical's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Jinan Acetate Chemical had liabilities of NT$1.07b due within 12 months and liabilities of NT$618.5m due beyond that. On the other hand, it had cash of NT$1.02b and NT$589.1m worth of receivables due within a year. So its liabilities total NT$78.9m more than the combination of its cash and short-term receivables.
Having regard to Jinan Acetate Chemical's size, it seems that its liquid assets are well balanced with its total liabilities. So it's very unlikely that the NT$6.17b company is short on cash, but still worth keeping an eye on the balance sheet. While it does have liabilities worth noting, Jinan Acetate Chemical also has more cash than debt, so we're pretty confident it can manage its debt safely.
In addition to that, we're happy to report that Jinan Acetate Chemical has boosted its EBIT by 54%, thus reducing the spectre of future debt repayments. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Jinan Acetate Chemical can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. Jinan Acetate Chemical may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. In the last three years, Jinan Acetate Chemical's free cash flow amounted to 44% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
We could understand if investors are concerned about Jinan Acetate Chemical's liabilities, but we can be reassured by the fact it has has net cash of NT$11.9m. And we liked the look of last year's 54% year-on-year EBIT growth. So we don't think Jinan Acetate Chemical's use of debt is risky. 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. Be aware that Jinan Acetate Chemical is showing 2 warning signs in our investment analysis , you should know about...
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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