Here's Why Formosa Laboratories (TPE:4746) Has A Meaningful Debt Burden

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 can see that Formosa Laboratories, Inc. (TPE:4746) does use debt in its business. But is this debt a concern to shareholders?

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. If things get really bad, the lenders can take control of the business. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Formosa Laboratories

What Is Formosa Laboratories's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Formosa Laboratories had NT$3.43b of debt in December 2020, down from NT$4.07b, one year before. However, it also had NT$812.2m in cash, and so its net debt is NT$2.62b.

How Strong Is Formosa Laboratories' Balance Sheet?

The latest balance sheet data shows that Formosa Laboratories had liabilities of NT$3.04b due within a year, and liabilities of NT$1.96b falling due after that. Offsetting these obligations, it had cash of NT$812.2m as well as receivables valued at NT$784.8m due within 12 months. So it has liabilities totalling NT$3.40b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Formosa Laboratories has a market capitalization of NT$6.41b, 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 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).

Weak interest cover of 1.0 times and a disturbingly high net debt to EBITDA ratio of 5.6 hit our confidence in Formosa Laboratories like a one-two punch to the gut. The debt burden here is substantial. However, one redeeming factor is that Formosa Laboratories grew its EBIT at 12% over the last 12 months, boosting its ability to handle its debt. 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 Laboratories 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Formosa Laboratories saw substantial negative free cash flow, in total. 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

To be frank both Formosa Laboratories's interest cover and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But at least it's pretty decent at growing its EBIT; that's encouraging. Overall, we think it's fair to say that Formosa Laboratories has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. 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 instance, we've identified 4 warning signs for Formosa Laboratories (2 are significant) 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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