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. Importantly, JSL Construction & Development Co., Ltd. (TPE:2540) does carry debt. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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.
What Is JSL Construction & Development's Debt?
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, it also had NT$1.28b in cash, and so its net debt is NT$6.09b.
How Strong Is JSL Construction & Development's Balance Sheet?
The latest balance sheet data shows that JSL Construction & Development had liabilities of NT$7.76b due within a year, and liabilities of NT$2.55b falling due after that. Offsetting these obligations, it had cash of NT$1.28b as well as receivables valued at NT$1.47b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$7.56b.
This is a mountain of leverage relative to its market capitalization of NT$9.60b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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).
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. But the good news is that it boasts fairly comforting interest cover of 6.3 times, suggesting it can responsibly service its obligations. Pleasingly, JSL Construction & Development is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 329% gain in the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But it is JSL Construction & Development'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, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, JSL Construction & Development 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.
To be frank both JSL Construction & Development's net debt to EBITDA and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Once we consider all the factors above, together, it seems to us that JSL Construction & Development's debt is making it 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. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. We've identified 1 warning sign with JSL Construction & Development , and understanding them should be part of your investment process.
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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