Here's Why Founding Construction & Development (TPE:5533) Has A Meaningful Debt Burden

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. We note that Founding Construction & Development Co., Ltd. (TPE:5533) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Founding Construction & Development

What Is Founding Construction & Development's Debt?

You can click the graphic below for the historical numbers, but it shows that Founding Construction & Development had NT$5.80b of debt in December 2020, down from NT$6.59b, one year before. However, because it has a cash reserve of NT$522.0m, its net debt is less, at about NT$5.28b.

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

According to the last reported balance sheet, Founding Construction & Development had liabilities of NT$4.41b due within 12 months, and liabilities of NT$2.14b due beyond 12 months. Offsetting these obligations, it had cash of NT$522.0m as well as receivables valued at NT$115.4m due within 12 months. So its liabilities total NT$5.91b more than the combination of its cash and short-term receivables.

Given this deficit is actually higher than the company's market capitalization of NT$4.72b, we think shareholders really should watch Founding Construction & Development's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). 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).

While Founding Construction & Development's debt to EBITDA ratio of 13.2 suggests a heavy debt load, its interest coverage of 7.6 implies it services that debt with ease. Our best guess is that the company does indeed have significant debt obligations. It is well worth noting that Founding Construction & Development's EBIT shot up like bamboo after rain, gaining 85% in the last twelve months. That'll make it easier to manage its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Founding 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Founding Construction & Development produced sturdy free cash flow equating to 69% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Founding Construction & Development's net debt to EBITDA and level of total liabilities definitely weigh on it, in our esteem. But its EBIT growth rate tells a very different story, and suggests some resilience. We think that Founding Construction & Development's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 3 warning signs for Founding Construction & Development (2 are significant) you should be aware of.

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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