Does Fong-Chien ConstructionLTD (GTSM:5523) Have A Healthy Balance Sheet?

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. We note that Fong-Chien Construction Co.,LTD. (GTSM:5523) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

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. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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.

See our latest analysis for Fong-Chien ConstructionLTD

How Much Debt Does Fong-Chien ConstructionLTD Carry?

As you can see below, at the end of December 2020, Fong-Chien ConstructionLTD had NT$2.53b of debt, up from NT$2.42b a year ago. Click the image for more detail. However, it does have NT$197.2m in cash offsetting this, leading to net debt of about NT$2.33b.

How Strong Is Fong-Chien ConstructionLTD's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Fong-Chien ConstructionLTD had liabilities of NT$2.52b due within 12 months and liabilities of NT$1.08b due beyond that. Offsetting these obligations, it had cash of NT$197.2m as well as receivables valued at NT$80.2m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$3.32b.

This deficit is considerable relative to its market capitalization of NT$3.53b, so it does suggest shareholders should keep an eye on Fong-Chien ConstructionLTD's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Fong-Chien ConstructionLTD has a rather high debt to EBITDA ratio of 47.5 which suggests a meaningful debt load. However, its interest coverage of 5.0 is reasonably strong, which is a good sign. One way Fong-Chien ConstructionLTD could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 19%, as it did over the last year. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Fong-Chien ConstructionLTD 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 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, Fong-Chien ConstructionLTD 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, Fong-Chien ConstructionLTD's net debt to EBITDA left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at growing its EBIT; that's encouraging. Looking at the bigger picture, it seems clear to us that Fong-Chien ConstructionLTD's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. 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. For instance, we've identified 3 warning signs for Fong-Chien ConstructionLTD (1 is a bit concerning) you should be aware of.

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. 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.
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