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 Kuo Yang Construction Co.,Ltd (TPE:2505) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
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. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.
Check out our latest analysis for Kuo Yang ConstructionLtd
How Much Debt Does Kuo Yang ConstructionLtd Carry?
You can click the graphic below for the historical numbers, but it shows that as of September 2019 Kuo Yang ConstructionLtd had NT$8.10b of debt, an increase on NT$7.69b, over one year. However, it does have NT$1.21b in cash offsetting this, leading to net debt of about NT$6.89b.
A Look At Kuo Yang ConstructionLtd's Liabilities
According to the last reported balance sheet, Kuo Yang ConstructionLtd had liabilities of NT$9.89b due within 12 months, and liabilities of NT$91.2m due beyond 12 months. Offsetting these obligations, it had cash of NT$1.21b as well as receivables valued at NT$380.5m due within 12 months. So it has liabilities totalling NT$8.39b more than its cash and near-term receivables, combined.
This is a mountain of leverage relative to its market capitalization of NT$13.5b. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry.
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).
Kuo Yang ConstructionLtd has a rather high debt to EBITDA ratio of 52.6 which suggests a meaningful debt load. However, its interest coverage of 3.8 is reasonably strong, which is a good sign. However, the silver lining was that Kuo Yang ConstructionLtd achieved a positive EBIT of NT$126m in the last twelve months, an improvement on the prior year's loss. There's no doubt that we learn most about debt from the balance sheet. But it is Kuo Yang ConstructionLtd'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 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, Kuo Yang ConstructionLtd 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 Kuo Yang ConstructionLtd'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 at least its EBIT growth rate is not so bad. We're quite clear that we consider Kuo Yang ConstructionLtd to be really rather risky, as a result of its balance sheet health. 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. Like risks, for instance. Every company has them, and we've spotted 5 warning signs for Kuo Yang ConstructionLtd (of which 2 are a bit unpleasant!) you should know about.
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.
If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. 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. Simply Wall St has no position in the stocks mentioned.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.