We Think King's Town Construction (TPE:2524) Can Stay On Top Of Its 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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, King's Town Construction Co., Ltd. (TPE:2524) does carry debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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 think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for King's Town Construction

What Is King's Town Construction's Debt?

You can click the graphic below for the historical numbers, but it shows that King's Town Construction had NT$15.9b of debt in September 2020, down from NT$20.3b, one year before. However, it does have NT$325.8m in cash offsetting this, leading to net debt of about NT$15.5b.

A Look At King's Town Construction's Liabilities

The latest balance sheet data shows that King's Town Construction had liabilities of NT$10.5b due within a year, and liabilities of NT$7.26b falling due after that. On the other hand, it had cash of NT$325.8m and NT$142.6m worth of receivables due within a year. So its liabilities total NT$17.3b more than the combination of its cash and short-term receivables.

Given this deficit is actually higher than the company's market capitalization of NT$14.7b, we think shareholders really should watch King's Town Construction's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While King's Town Construction's debt to EBITDA ratio of 6.9 suggests a heavy debt load, its interest coverage of 8.3 implies it services that debt with ease. Overall we'd say it seems likely the company is carrying a fairly heavy swag of debt. Importantly, King's Town Construction grew its EBIT by 44% over the last twelve months, and that growth will make it easier to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But it is King's Town Construction's earnings that will influence how the balance sheet holds up in the future. 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's worth checking how much of that EBIT is backed by free cash flow. During the last three years, King's Town Construction generated free cash flow amounting to a very robust 93% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Our View

Based on what we've seen King's Town Construction is not finding it easy, given its net debt to EBITDA, but the other factors we considered give us cause to be optimistic. In particular, we are dazzled with its conversion of EBIT to free cash flow. When we consider all the factors mentioned above, we do feel a bit cautious about King's Town Construction's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 1 warning sign for King's Town Construction that 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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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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