Does Taiwan Hon Chuan Enterprise (TWSE:9939) Have A Healthy Balance Sheet?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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 Taiwan Hon Chuan Enterprise Co., Ltd. (TWSE:9939) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Taiwan Hon Chuan Enterprise

What Is Taiwan Hon Chuan Enterprise's Net Debt?

As you can see below, at the end of December 2023, Taiwan Hon Chuan Enterprise had NT$17.8b of debt, up from NT$17.0b a year ago. Click the image for more detail. However, it also had NT$6.21b in cash, and so its net debt is NT$11.6b.

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

According to the last reported balance sheet, Taiwan Hon Chuan Enterprise had liabilities of NT$11.0b due within 12 months, and liabilities of NT$10.4b due beyond 12 months. Offsetting these obligations, it had cash of NT$6.21b as well as receivables valued at NT$4.35b due within 12 months. So its liabilities total NT$10.8b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Taiwan Hon Chuan Enterprise has a market capitalization of NT$48.3b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Taiwan Hon Chuan Enterprise's net debt to EBITDA ratio of about 2.1 suggests only moderate use of debt. And its commanding EBIT of 20.9 times its interest expense, implies the debt load is as light as a peacock feather. One way Taiwan Hon Chuan Enterprise could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 14%, as it did over the last year. The balance sheet is clearly the area to focus on when you are analysing debt. 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 want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. 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 40% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

The good news is that Taiwan Hon Chuan Enterprise's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And we also thought its EBIT growth rate was a positive. Looking at all the aforementioned factors together, it strikes us that Taiwan Hon Chuan Enterprise can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. 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. For example - Taiwan Hon Chuan Enterprise has 2 warning signs we think you should be aware of.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.