These 4 Measures Indicate That Sunty Development (TPE:3266) Is Using Debt Extensively

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 Sunty Development Co., LTD (TPE:3266) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Sunty Development

How Much Debt Does Sunty Development Carry?

You can click the graphic below for the historical numbers, but it shows that Sunty Development had NT$2.77b of debt in September 2020, down from NT$2.93b, one year before. However, it does have NT$1.50b in cash offsetting this, leading to net debt of about NT$1.27b.

How Healthy Is Sunty Development's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Sunty Development had liabilities of NT$5.22b due within 12 months and liabilities of NT$444.4m due beyond that. On the other hand, it had cash of NT$1.50b and NT$378.9m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$3.78b.

This deficit is considerable relative to its market capitalization of NT$5.44b, so it does suggest shareholders should keep an eye on Sunty Development's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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).

As it happens Sunty Development has a fairly concerning net debt to EBITDA ratio of 5.7 but very strong interest coverage of 549. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. Also relevant is that Sunty Development has grown its EBIT by a very respectable 25% in the last year, thus enhancing its ability to pay down debt. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Sunty 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, 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. Over the last three years, Sunty 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

While Sunty Development's conversion of EBIT to free cash flow has us nervous. To wit both its interest cover and EBIT growth rate were encouraging signs. When we consider all the factors discussed, it seems to us that Sunty Development is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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 - Sunty Development has 2 warning signs (and 1 which can't be ignored) we think 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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