Is Kuo Yang ConstructionLtd (TPE:2505) 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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Kuo Yang Construction Co.,Ltd (TPE:2505) does carry debt. 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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Kuo Yang ConstructionLtd

What Is Kuo Yang ConstructionLtd's Net Debt?

As you can see below, Kuo Yang ConstructionLtd had NT$5.83b of debt at September 2020, down from NT$8.10b a year prior. However, it does have NT$6.16b in cash offsetting this, leading to net cash of NT$330.4m.

How Healthy Is Kuo Yang ConstructionLtd's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Kuo Yang ConstructionLtd had liabilities of NT$8.37b due within 12 months and liabilities of NT$72.0m due beyond that. On the other hand, it had cash of NT$6.16b and NT$570.1m worth of receivables due within a year. So it has liabilities totalling NT$1.71b more than its cash and near-term receivables, combined.

Of course, Kuo Yang ConstructionLtd has a market capitalization of NT$17.5b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. Despite its noteworthy liabilities, Kuo Yang ConstructionLtd boasts net cash, so it's fair to say it does not have a heavy debt load!

Better yet, Kuo Yang ConstructionLtd grew its EBIT by 3,815% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Kuo Yang 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. Kuo Yang ConstructionLtd may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Happily for any shareholders, Kuo Yang ConstructionLtd actually produced more free cash flow than EBIT over the last two years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Summing up

While it is always sensible to look at a company's total liabilities, it is very reassuring that Kuo Yang ConstructionLtd has NT$330.4m in net cash. The cherry on top was that in converted 160% of that EBIT to free cash flow, bringing in NT$8.4b. So we don't think Kuo Yang ConstructionLtd's use of debt is risky. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Take risks, for example - Kuo Yang ConstructionLtd has 2 warning signs we think you should be aware of.

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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