Does Hua Yu Lien Development (TWSE:1436) 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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that Hua Yu Lien Development Co., Ltd (TWSE:1436) does have debt on its balance sheet. 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. 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. 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. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Hua Yu Lien Development

How Much Debt Does Hua Yu Lien Development Carry?

The image below, which you can click on for greater detail, shows that at December 2023 Hua Yu Lien Development had debt of NT$9.48b, up from NT$8.33b in one year. However, because it has a cash reserve of NT$665.3m, its net debt is less, at about NT$8.82b.

How Healthy Is Hua Yu Lien Development's Balance Sheet?

We can see from the most recent balance sheet that Hua Yu Lien Development had liabilities of NT$8.39b falling due within a year, and liabilities of NT$2.75b due beyond that. On the other hand, it had cash of NT$665.3m and NT$88.9m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$10.4b.

This is a mountain of leverage relative to its market capitalization of NT$12.3b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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.

Strangely Hua Yu Lien Development has a sky high EBITDA ratio of 7.9, implying high debt, but a strong interest coverage of 13.3. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. We note that Hua Yu Lien Development grew its EBIT by 27% in the last year, and that should make it easier to pay down debt, going forward. When analysing debt levels, the balance sheet is the obvious place to start. But it is Hua Yu Lien Development's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

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. During the last three years, Hua Yu Lien Development burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

While Hua Yu Lien Development's conversion of EBIT to free cash flow has us nervous. For example, its interest cover and EBIT growth rate give us some confidence in its ability to manage its debt. Taking the abovementioned factors together we do think Hua Yu Lien Development's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. 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. To that end, you should learn about the 3 warning signs we've spotted with Hua Yu Lien Development (including 1 which is potentially serious) .

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.