These 4 Measures Indicate That Long Bon InternationalLtd (TPE:2514) Is Using Debt In A Risky Way

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.' 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 Long Bon International Co.,Ltd (TPE:2514) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Long Bon InternationalLtd

What Is Long Bon InternationalLtd's Debt?

The image below, which you can click on for greater detail, shows that at September 2020 Long Bon InternationalLtd had debt of NT$6.49b, up from NT$5.45b in one year. However, because it has a cash reserve of NT$2.06b, its net debt is less, at about NT$4.43b.

How Strong Is Long Bon InternationalLtd's Balance Sheet?

According to the last reported balance sheet, Long Bon InternationalLtd had liabilities of NT$7.27b due within 12 months, and liabilities of NT$6.07b due beyond 12 months. Offsetting these obligations, it had cash of NT$2.06b as well as receivables valued at NT$3.36b due within 12 months. So its liabilities total NT$7.93b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the NT$5.05b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, Long Bon InternationalLtd would probably need a major re-capitalization if its creditors were to demand repayment.

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).

Long Bon InternationalLtd has a rather high debt to EBITDA ratio of 22.1 which suggests a meaningful debt load. However, its interest coverage of 2.6 is reasonably strong, which is a good sign. Worse, Long Bon InternationalLtd's EBIT was down 85% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is Long Bon InternationalLtd'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, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last two years, Long Bon InternationalLtd burned a lot of cash. 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

On the face of it, Long Bon InternationalLtd's conversion of EBIT to free cash flow left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. And even its level of total liabilities fails to inspire much confidence. Considering everything we've mentioned above, it's fair to say that Long Bon InternationalLtd is carrying heavy debt load. If you harvest honey without a bee suit, you risk getting stung, so we'd probably stay away from this particular stock. 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. Case in point: We've spotted 2 warning signs for Long Bon InternationalLtd you should be aware of, and 1 of them can't be ignored.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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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