Is Li Ming Development Construction (GTSM:6212) A Risky Investment?

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.' 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. As with many other companies Li Ming Development Construction Co., Ltd. (GTSM:6212) makes use of debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Li Ming Development Construction

What Is Li Ming Development Construction's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2020 Li Ming Development Construction had debt of NT$5.67b, up from NT$2.76b in one year. However, it does have NT$129.6m in cash offsetting this, leading to net debt of about NT$5.54b.

A Look At Li Ming Development Construction's Liabilities

We can see from the most recent balance sheet that Li Ming Development Construction had liabilities of NT$7.83b falling due within a year, and liabilities of NT$1.38m due beyond that. Offsetting these obligations, it had cash of NT$129.6m as well as receivables valued at NT$52.0k due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$7.70b.

When you consider that this deficiency exceeds the company's NT$5.93b market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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). 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 Li Ming Development Construction has a fairly concerning net debt to EBITDA ratio of 37.9 but very strong interest coverage of 25.9. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. We also note that Li Ming Development Construction improved its EBIT from a last year's loss to a positive NT$146m. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Li Ming Development Construction 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. During the last year, Li Ming Development Construction burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both Li Ming Development Construction's net debt to EBITDA and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Overall, it seems to us that Li Ming Development Construction's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Consider for instance, the ever-present spectre of investment risk. We've identified 3 warning signs with Li Ming Development Construction , and understanding them should be part of your investment process.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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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