Hung Ching Development & Construction (TPE:2527) Has A Somewhat Strained Balance Sheet

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 can see that Hung Ching Development & Construction Co. Ltd. (TPE:2527) 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 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. If things get really bad, the lenders can take control of the business. 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.

View our latest analysis for Hung Ching Development & Construction

How Much Debt Does Hung Ching Development & Construction Carry?

As you can see below, Hung Ching Development & Construction had NT$7.97b of debt at September 2020, down from NT$8.41b a year prior. However, it does have NT$319.3m in cash offsetting this, leading to net debt of about NT$7.65b.

A Look At Hung Ching Development & Construction's Liabilities

We can see from the most recent balance sheet that Hung Ching Development & Construction had liabilities of NT$7.22b falling due within a year, and liabilities of NT$2.12b due beyond that. Offsetting these obligations, it had cash of NT$319.3m as well as receivables valued at NT$135.5m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$8.89b.

This deficit casts a shadow over the NT$5.01b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Hung Ching Development & Construction would likely require a major re-capitalisation if it had to pay its creditors today.

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).

Strangely Hung Ching Development & Construction has a sky high EBITDA ratio of 13.8, implying high debt, but a strong interest coverage of 16.2. So either it has access to very cheap long term debt or that interest expense is going to grow! Shareholders should be aware that Hung Ching Development & Construction's EBIT was down 73% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Hung Ching Development & Construction will need earnings to service that debt. 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 we always check how much of that EBIT is translated into free cash flow. Happily for any shareholders, Hung Ching Development & Construction actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

To be frank both Hung Ching Development & Construction's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its interest cover is a good sign, and makes us more optimistic. We're quite clear that we consider Hung Ching Development & Construction to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 2 warning signs for Hung Ching Development & Construction (1 doesn't sit too well with us!) that you should be aware of before investing here.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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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