Is Huang Hsiang Construction (TPE:2545) Using Too Much Debt?

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.' 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, Huang Hsiang Construction Corporation (TPE:2545) does carry debt. But should shareholders be worried about its use of debt?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Huang Hsiang Construction

What Is Huang Hsiang Construction's Debt?

The chart below, which you can click on for greater detail, shows that Huang Hsiang Construction had NT$27.3b in debt in September 2020; about the same as the year before. However, it does have NT$1.43b in cash offsetting this, leading to net debt of about NT$25.9b.

How Healthy Is Huang Hsiang Construction's Balance Sheet?

According to the last reported balance sheet, Huang Hsiang Construction had liabilities of NT$18.7b due within 12 months, and liabilities of NT$11.0b due beyond 12 months. Offsetting these obligations, it had cash of NT$1.43b as well as receivables valued at NT$521.6m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$27.7b.

The deficiency here weighs heavily on the NT$11.9b 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. At the end of the day, Huang Hsiang Construction would probably need a major re-capitalization if its creditors were to demand repayment.

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 12.9, it's fair to say Huang Hsiang Construction does have a significant amount of debt. However, its interest coverage of 5.1 is reasonably strong, which is a good sign. Pleasingly, Huang Hsiang Construction is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 1,306% gain in the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But it is Huang Hsiang 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 we always check how much of that EBIT is translated into free cash flow. Happily for any shareholders, Huang Hsiang Construction actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

We feel some trepidation about Huang Hsiang Construction's difficulty level of total liabilities, but we've got positives to focus on, too. To wit both its conversion of EBIT to free cash flow and EBIT growth rate were encouraging signs. We think that Huang Hsiang Construction's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for Huang Hsiang Construction (of which 2 don't sit too well with us!) you should know about.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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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