Here's Why Kee Tai Properties (TPE:2538) Is Weighed Down By Its Debt Load

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. We can see that Kee Tai Properties Co. Ltd. (TPE:2538) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. 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. 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.

View our latest analysis for Kee Tai Properties

What Is Kee Tai Properties's Debt?

As you can see below, at the end of September 2020, Kee Tai Properties had NT$11.4b of debt, up from NT$10.8b a year ago. Click the image for more detail. However, because it has a cash reserve of NT$319.9m, its net debt is less, at about NT$11.1b.

How Strong Is Kee Tai Properties' Balance Sheet?

The latest balance sheet data shows that Kee Tai Properties had liabilities of NT$6.49b due within a year, and liabilities of NT$6.98b falling due after that. Offsetting this, it had NT$319.9m in cash and NT$215.9m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$12.9b.

The deficiency here weighs heavily on the NT$4.30b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. After all, Kee Tai Properties would likely require a major re-capitalisation if it had to pay its creditors today.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).

Kee Tai Properties shareholders face the double whammy of a high net debt to EBITDA ratio (284), and fairly weak interest coverage, since EBIT is just 0.31 times the interest expense. The debt burden here is substantial. One redeeming factor for Kee Tai Properties is that it turned last year's EBIT loss into a gain of NT$12m, over the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Kee Tai Properties 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. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. During the last year, Kee Tai Properties 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, Kee Tai Properties's conversion of EBIT to free cash flow left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least its EBIT growth rate is not so bad. Considering all the factors previously mentioned, we think that Kee Tai Properties really is carrying too much debt. To us, that makes the stock rather risky, like walking through a dog park with your eyes closed. But some investors may feel differently. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 3 warning signs for Kee Tai Properties (2 shouldn't be ignored) you should be aware of.

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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