We Think Froch Enterprise (TWSE:2030) Is Taking Some Risk With Its 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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies Froch Enterprise Co., Ltd. (TWSE:2030) makes use of debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. 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 Froch Enterprise

How Much Debt Does Froch Enterprise Carry?

The chart below, which you can click on for greater detail, shows that Froch Enterprise had NT$6.10b in debt in September 2024; about the same as the year before. However, it also had NT$1.29b in cash, and so its net debt is NT$4.82b.

A Look At Froch Enterprise's Liabilities

Zooming in on the latest balance sheet data, we can see that Froch Enterprise had liabilities of NT$3.86b due within 12 months and liabilities of NT$3.26b due beyond that. On the other hand, it had cash of NT$1.29b and NT$1.28b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$4.55b.

This deficit is considerable relative to its market capitalization of NT$5.16b, so it does suggest shareholders should keep an eye on Froch 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 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Froch Enterprise shareholders face the double whammy of a high net debt to EBITDA ratio (8.7), and fairly weak interest coverage, since EBIT is just 2.2 times the interest expense. This means we'd consider it to have a heavy debt load. The good news is that Froch Enterprise improved its EBIT by 7.9% over the last twelve months, thus gradually reducing its debt levels relative to its earnings. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Froch Enterprise 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Froch Enterprise generated free cash flow amounting to a very robust 92% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Our View

Neither Froch Enterprise's ability handle its debt, based on its EBITDA, nor its interest cover gave us confidence in its ability to take on more debt. But its conversion of EBIT to free cash flow tells a very different story, and suggests some resilience. When we consider all the factors discussed, it seems to us that Froch Enterprise is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for Froch Enterprise (of which 2 are potentially serious!) 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.

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.