Is Chong Hong Construction (TWSE:5534) Using Too Much Debt?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 can see that Chong Hong Construction Co., Ltd. (TWSE:5534) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Chong Hong Construction

What Is Chong Hong Construction's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Chong Hong Construction had NT$17.8b of debt in June 2024, down from NT$19.6b, one year before. However, it does have NT$1.75b in cash offsetting this, leading to net debt of about NT$16.0b.

A Look At Chong Hong Construction's Liabilities

Zooming in on the latest balance sheet data, we can see that Chong Hong Construction had liabilities of NT$28.0b due within 12 months and liabilities of NT$69.7m due beyond that. Offsetting these obligations, it had cash of NT$1.75b as well as receivables valued at NT$580.1m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$25.7b.

This is a mountain of leverage relative to its market capitalization of NT$30.8b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

As it happens Chong Hong Construction has a fairly concerning net debt to EBITDA ratio of 6.0 but very strong interest coverage of 273. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. Importantly, Chong Hong Construction grew its EBIT by 80% over the last twelve months, and that growth will make it easier to handle its debt. 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 Chong Hong Construction's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Chong Hong Construction created free cash flow amounting to 15% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

While Chong Hong Construction's net debt to EBITDA has us nervous. For example, its interest cover and EBIT growth rate give us some confidence in its ability to manage its debt. Looking at all the angles mentioned above, it does seem to us that Chong Hong Construction is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. Be aware that Chong Hong Construction is showing 3 warning signs in our investment analysis , you should know about...

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.