Does JSL Construction & Development (TPE:2540) Have A Healthy Balance Sheet?

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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that JSL Construction & Development Co., Ltd. (TPE:2540) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. 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. 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 examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for JSL Construction & Development

How Much Debt Does JSL Construction & Development Carry?

The image below, which you can click on for greater detail, shows that at September 2020 JSL Construction & Development had debt of NT$7.36b, up from NT$6.57b in one year. However, because it has a cash reserve of NT$1.28b, its net debt is less, at about NT$6.09b.

How Healthy Is JSL Construction & Development's Balance Sheet?

According to the last reported balance sheet, JSL Construction & Development had liabilities of NT$7.76b due within 12 months, and liabilities of NT$2.55b due beyond 12 months. Offsetting this, it had NT$1.28b in cash and NT$1.47b in receivables that were due within 12 months. So it has liabilities totalling NT$7.56b more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of NT$10.2b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

With a net debt to EBITDA ratio of 5.4, it's fair to say JSL Construction & Development does have a significant amount of debt. However, its interest coverage of 6.3 is reasonably strong, which is a good sign. Notably, JSL Construction & Development's EBIT launched higher than Elon Musk, gaining a whopping 329% on last year. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since JSL Construction & Development 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 we always check how much of that EBIT is translated into free cash flow. Over the last three years, JSL Construction & Development saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

On the face of it, JSL Construction & Development's net debt to EBITDA left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making JSL Construction & Development stock a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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. Take risks, for example - JSL Construction & Development has 2 warning signs (and 1 which makes us a bit uncomfortable) we think you should know about.

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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