Here's Why Huaku Development (TWSE:2548) Can Manage Its Debt Responsibly

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.' 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 Huaku Development Co., Ltd. (TWSE:2548) makes use of debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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 Huaku Development

What Is Huaku Development's Debt?

The image below, which you can click on for greater detail, shows that at December 2023 Huaku Development had debt of NT$16.2b, up from NT$14.9b in one year. However, because it has a cash reserve of NT$1.55b, its net debt is less, at about NT$14.7b.

How Healthy Is Huaku Development's Balance Sheet?

The latest balance sheet data shows that Huaku Development had liabilities of NT$19.9b due within a year, and liabilities of NT$2.93b falling due after that. Offsetting these obligations, it had cash of NT$1.55b as well as receivables valued at NT$186.7m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$21.1b.

This deficit isn't so bad because Huaku Development is worth NT$45.9b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Huaku Development's net debt is 3.4 times its EBITDA, which is a significant but still reasonable amount of leverage. However, its interest coverage of 84.1 is very high, suggesting that the interest expense on the debt is currently quite low. One way Huaku Development could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 17%, as it did over the last year. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Huaku Development will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Huaku Development's free cash flow amounted to 33% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

When it comes to the balance sheet, the standout positive for Huaku Development was the fact that it seems able to cover its interest expense with its EBIT confidently. However, our other observations weren't so heartening. For example, its net debt to EBITDA makes us a little nervous about its debt. When we consider all the factors mentioned above, we do feel a bit cautious about Huaku Development's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 2 warning signs for Huaku Development that you should be aware of before investing here.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.