Yung Zip Chemical Ind (GTSM:4102) Seems To Use Debt Quite Sensibly

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.' 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 Yung Zip Chemical Ind. Co., Ltd. (GTSM:4102) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Yung Zip Chemical Ind

What Is Yung Zip Chemical Ind's Net Debt?

The image below, which you can click on for greater detail, shows that at December 2020 Yung Zip Chemical Ind had debt of NT$258.2m, up from NT$75.0m in one year. However, it does have NT$53.4m in cash offsetting this, leading to net debt of about NT$204.8m.

A Look At Yung Zip Chemical Ind's Liabilities

We can see from the most recent balance sheet that Yung Zip Chemical Ind had liabilities of NT$165.2m falling due within a year, and liabilities of NT$216.1m due beyond that. Offsetting this, it had NT$53.4m in cash and NT$109.4m in receivables that were due within 12 months. So its liabilities total NT$218.6m more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Yung Zip Chemical Ind has a market capitalization of NT$997.9m, 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.

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.

Yung Zip Chemical Ind has a debt to EBITDA ratio of 3.1, which signals significant debt, but is still pretty reasonable for most types of business. However, its interest coverage of 20.1 is very high, suggesting that the interest expense on the debt is currently quite low. Importantly, Yung Zip Chemical Ind grew its EBIT by 34% over the last twelve months, and that growth will make it easier to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Yung Zip Chemical Ind can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last two years, Yung Zip Chemical Ind's free cash flow amounted to 25% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Happily, Yung Zip Chemical Ind's impressive interest cover implies it has the upper hand on its debt. But truth be told we feel its conversion of EBIT to free cash flow does undermine this impression a bit. All these things considered, it appears that Yung Zip Chemical Ind can comfortably handle its current debt levels. 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. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 2 warning signs for Yung Zip Chemical Ind (1 doesn't sit too well with us!) that you should be aware of before investing here.

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. 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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