Fong-Chien ConstructionLTD (GTSM:5523) Use Of Debt Could Be Considered Risky

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 Fong-Chien Construction Co.,LTD. (GTSM:5523) does use debt in its business. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Fong-Chien ConstructionLTD

What Is Fong-Chien ConstructionLTD's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2020 Fong-Chien ConstructionLTD had debt of NT$2.66b, up from NT$2.37b in one year. However, it also had NT$78.6m in cash, and so its net debt is NT$2.58b.

How Healthy 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$2.12b due within 12 months and liabilities of NT$1.13b due beyond that. Offsetting these obligations, it had cash of NT$78.6m as well as receivables valued at NT$55.5m due within 12 months. So its liabilities total NT$3.11b more than the combination of its cash and short-term receivables.

Given this deficit is actually higher than the company's market capitalization of NT$2.56b, we think shareholders really should watch Fong-Chien ConstructionLTD's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Fong-Chien ConstructionLTD shareholders face the double whammy of a high net debt to EBITDA ratio (183), and fairly weak interest coverage, since EBIT is just 0.90 times the interest expense. The debt burden here is substantial. Even worse, Fong-Chien ConstructionLTD saw its EBIT tank 82% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. When analysing debt levels, the balance sheet is the obvious place to start. But it is Fong-Chien ConstructionLTD's earnings that will influence how the balance sheet holds up in the future. 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 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, 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

To be frank both Fong-Chien ConstructionLTD's conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. And even its net debt to EBITDA fails to inspire much confidence. Considering all the factors previously mentioned, we think that Fong-Chien ConstructionLTD really is carrying too much debt. To our minds, that means the stock is rather high risk, and probably one to avoid; but to each their own (investing) style. The balance sheet is clearly the area to focus on when you are analysing debt. 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 Fong-Chien ConstructionLTD (including 1 which is is concerning) .

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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