Wei Chih Steel Industrial (TWSE:2028) Takes On Some Risk With Its Use Of Debt

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 Wei Chih Steel Industrial Co., Ltd. (TWSE:2028) does use debt in its business. But is this debt a concern to shareholders?

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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Wei Chih Steel Industrial

How Much Debt Does Wei Chih Steel Industrial Carry?

As you can see below, at the end of June 2024, Wei Chih Steel Industrial had NT$3.01b of debt, up from NT$2.18b a year ago. Click the image for more detail. On the flip side, it has NT$285.0m in cash leading to net debt of about NT$2.72b.

How Healthy Is Wei Chih Steel Industrial's Balance Sheet?

The latest balance sheet data shows that Wei Chih Steel Industrial had liabilities of NT$3.26b due within a year, and liabilities of NT$1.48b falling due after that. Offsetting this, it had NT$285.0m in cash and NT$746.4m in receivables that were due within 12 months. So its liabilities total NT$3.71b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Wei Chih Steel Industrial has a market capitalization of NT$8.65b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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.

Wei Chih Steel Industrial has a debt to EBITDA ratio of 3.9, which signals significant debt, but is still pretty reasonable for most types of business. But its EBIT was about 13.3 times its interest expense, implying the company isn't really paying a high cost to maintain that level of debt. Even were the low cost to prove unsustainable, that is a good sign. Importantly, Wei Chih Steel Industrial's EBIT fell a jaw-dropping 30% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Wei Chih Steel Industrial 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, Wei Chih Steel Industrial recorded free cash flow of 23% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

We'd go so far as to say Wei Chih Steel Industrial's EBIT growth rate was disappointing. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Wei Chih Steel Industrial stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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. For instance, we've identified 2 warning signs for Wei Chih Steel Industrial (1 is concerning) you should be aware of.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.