Is Yungshin Construction & DevelopmentLtd (GTSM:5508) Using Too Much Debt?

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. As with many other companies Yungshin Construction & Development Co.,Ltd. (GTSM:5508) makes use of debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Yungshin Construction & DevelopmentLtd

What Is Yungshin Construction & DevelopmentLtd's Debt?

The image below, which you can click on for greater detail, shows that at September 2020 Yungshin Construction & DevelopmentLtd had debt of NT$5.69b, up from NT$4.55b in one year. And it doesn't have much cash, so its net debt is about the same.

How Healthy Is Yungshin Construction & DevelopmentLtd's Balance Sheet?

According to the last reported balance sheet, Yungshin Construction & DevelopmentLtd had liabilities of NT$4.60b due within 12 months, and liabilities of NT$1.74b due beyond 12 months. On the other hand, it had cash of NT$84.1m and NT$109.5m worth of receivables due within a year. So its liabilities total NT$6.15b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of NT$9.78b, so it does suggest shareholders should keep an eye on Yungshin Construction & DevelopmentLtd's use of debt. 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Strangely Yungshin Construction & DevelopmentLtd has a sky high EBITDA ratio of 8.9, implying high debt, but a strong interest coverage of 1k. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. It is well worth noting that Yungshin Construction & DevelopmentLtd's EBIT shot up like bamboo after rain, gaining 49% in the last twelve months. That'll make it easier to manage its debt. There's no doubt that we learn most about debt from the balance sheet. But it is Yungshin Construction & DevelopmentLtd's earnings that will influence how the balance sheet holds up in the future. 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Yungshin Construction & DevelopmentLtd 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

We feel some trepidation about Yungshin Construction & DevelopmentLtd's difficulty conversion of EBIT to free cash flow, but we've got positives to focus on, too. To wit both its interest cover and EBIT growth rate were encouraging signs. When we consider all the factors discussed, it seems to us that Yungshin Construction & DevelopmentLtd is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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 Yungshin Construction & DevelopmentLtd (including 2 which is are a bit concerning) .

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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