Kunyue Development (GTSM:5206) Use Of Debt Could Be Considered Risky

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 Kunyue Development Co., Ltd. (GTSM:5206) does use debt in its business. But is this debt a concern to shareholders?

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. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Kunyue Development

What Is Kunyue Development's Debt?

As you can see below, at the end of September 2020, Kunyue Development had NT$4.21b of debt, up from NT$2.66b a year ago. Click the image for more detail. However, it also had NT$872.0m in cash, and so its net debt is NT$3.34b.

How Strong Is Kunyue Development's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Kunyue Development had liabilities of NT$5.15b due within 12 months and liabilities of NT$6.85m due beyond that. Offsetting this, it had NT$872.0m in cash and NT$6.47m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$4.28b.

This deficit casts a shadow over the NT$2.74b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Kunyue Development would likely require a major re-capitalisation if it had to pay its creditors today.

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). 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).

As it happens Kunyue Development has a fairly concerning net debt to EBITDA ratio of 8.4 but very strong interest coverage of 1k. So either it has access to very cheap long term debt or that interest expense is going to grow! Shareholders should be aware that Kunyue Development's EBIT was down 23% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Kunyue Development will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Kunyue Development 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

On the face of it, Kunyue Development's conversion of EBIT to free cash flow left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. After considering the datapoints discussed, we think Kunyue Development has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. 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 example Kunyue Development has 4 warning signs (and 2 which are a bit concerning) we think you should know about.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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