Formosa Chemicals & Fibre (TWSE:1326) Takes On Some Risk With Its Use Of Debt

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.' 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 Formosa Chemicals & Fibre Corporation (TWSE:1326) 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 is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Formosa Chemicals & Fibre

How Much Debt Does Formosa Chemicals & Fibre Carry?

You can click the graphic below for the historical numbers, but it shows that as of June 2024 Formosa Chemicals & Fibre had NT$158.1b of debt, an increase on NT$142.7b, over one year. On the flip side, it has NT$99.0b in cash leading to net debt of about NT$59.1b.

How Healthy Is Formosa Chemicals & Fibre's Balance Sheet?

The latest balance sheet data shows that Formosa Chemicals & Fibre had liabilities of NT$130.2b due within a year, and liabilities of NT$72.0b falling due after that. On the other hand, it had cash of NT$99.0b and NT$51.6b worth of receivables due within a year. So it has liabilities totalling NT$51.7b more than its cash and near-term receivables, combined.

Formosa Chemicals & Fibre has a market capitalization of NT$234.5b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without 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).

While Formosa Chemicals & Fibre's debt to EBITDA ratio (3.0) suggests that it uses some debt, its interest cover is very weak, at 2.3, suggesting high leverage. In large part that's due to the company's significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. One redeeming factor for Formosa Chemicals & Fibre is that it turned last year's EBIT loss into a gain of NT$3.8b, over the last twelve months. 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 Formosa Chemicals & Fibre 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. During the last year, Formosa Chemicals & Fibre burned a lot of cash. 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

We'd go so far as to say Formosa Chemicals & Fibre's conversion of EBIT to free cash flow was disappointing. But at least its level of total liabilities is not so bad. Once we consider all the factors above, together, it seems to us that Formosa Chemicals & Fibre's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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. For example, we've discovered 1 warning sign for Formosa Chemicals & Fibre that you should be aware of before investing here.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.