Is Taiwan Hon Chuan Enterprise (TPE:9939) Using Too Much Debt?

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.' 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. Importantly, Taiwan Hon Chuan Enterprise Co., Ltd. (TPE:9939) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Taiwan Hon Chuan Enterprise

What Is Taiwan Hon Chuan Enterprise's Net Debt?

As you can see below, Taiwan Hon Chuan Enterprise had NT$16.0b of debt, at September 2020, which is about the same as the year before. You can click the chart for greater detail. However, because it has a cash reserve of NT$3.93b, its net debt is less, at about NT$12.1b.

How Healthy Is Taiwan Hon Chuan Enterprise's Balance Sheet?

We can see from the most recent balance sheet that Taiwan Hon Chuan Enterprise had liabilities of NT$8.52b falling due within a year, and liabilities of NT$10.6b due beyond that. Offsetting this, it had NT$3.93b in cash and NT$4.09b in receivables that were due within 12 months. So its liabilities total NT$11.1b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of NT$17.3b, so it does suggest shareholders should keep an eye on Taiwan Hon Chuan Enterprise's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Taiwan Hon Chuan Enterprise has a debt to EBITDA ratio of 2.8, which signals significant debt, but is still pretty reasonable for most types of business. However, its interest coverage of 17.7 is very high, suggesting that the interest expense on the debt is currently quite low. Taiwan Hon Chuan Enterprise grew its EBIT by 5.5% in the last year. That's far from incredible but it is a good thing, when it comes to paying off debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Taiwan Hon Chuan Enterprise's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Taiwan Hon Chuan Enterprise's free cash flow amounted to 31% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

Neither Taiwan Hon Chuan Enterprise's ability to handle its total liabilities nor its conversion of EBIT to free cash flow gave us confidence in its ability to take on more debt. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. Looking at all the angles mentioned above, it does seem to us that Taiwan Hon Chuan Enterprise is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Consider risks, for instance. Every company has them, and we've spotted 1 warning sign for Taiwan Hon Chuan Enterprise 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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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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