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.' 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. We note that Pacific Construction Co., Ltd (TPE:2506) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.
What Is Pacific Construction's Debt?
As you can see below, Pacific Construction had NT$4.38b of debt, at September 2020, which is about the same as the year before. You can click the chart for greater detail. However, because it has a cash reserve of NT$765.0m, its net debt is less, at about NT$3.62b.
How Healthy Is Pacific Construction's Balance Sheet?
We can see from the most recent balance sheet that Pacific Construction had liabilities of NT$5.36b falling due within a year, and liabilities of NT$2.22b due beyond that. Offsetting these obligations, it had cash of NT$765.0m as well as receivables valued at NT$141.1m due within 12 months. So it has liabilities totalling NT$6.68b more than its cash and near-term receivables, combined.
This deficit casts a shadow over the NT$3.59b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. At the end of the day, Pacific Construction would probably need a major re-capitalization if its creditors were to demand repayment. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Pacific Construction'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.
In the last year Pacific Construction had a loss before interest and tax, and actually shrunk its revenue by 46%, to NT$848m. To be frank that doesn't bode well.
While Pacific Construction's falling revenue is about as heartwarming as a wet blanket, arguably its earnings before interest and tax (EBIT) loss is even less appealing. Indeed, it lost NT$174m at the EBIT level. Considering that alongside the liabilities mentioned above make us nervous about the company. It would need to improve its operations quickly for us to be interested in it. Not least because it had negative free cash flow of NT$7.2m over the last twelve months. So suffice it to say we consider the stock to be 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Pacific Construction you should know about.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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Pacific Construction Co., Ltd. engages in the construction business.
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Excellent balance sheet with solid track record.
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