These 4 Measures Indicate That Founding Construction & Development (TPE:5533) Is Using Debt Extensively

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.' 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, Founding Construction & Development Co., Ltd. (TPE:5533) does carry debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Founding Construction & Development

What Is Founding Construction & Development's Net Debt?

The chart below, which you can click on for greater detail, shows that Founding Construction & Development had NT$6.53b in debt in September 2020; about the same as the year before. However, it also had NT$669.4m in cash, and so its net debt is NT$5.86b.

A Look At Founding Construction & Development's Liabilities

According to the last reported balance sheet, Founding Construction & Development had liabilities of NT$4.84b due within 12 months, and liabilities of NT$2.26b due beyond 12 months. On the other hand, it had cash of NT$669.4m and NT$102.2m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$6.33b.

When you consider that this deficiency exceeds the company's NT$4.61b market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Founding Construction & Development has a rather high debt to EBITDA ratio of 25.6 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 3.2 times, suggesting it can responsibly service its obligations. Worse, Founding Construction & Development's EBIT was down 32% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is Founding Construction & Development's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. 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, Founding Construction & Development actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

To be frank both Founding Construction & Development's net debt to EBITDA and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Overall, it seems to us that Founding Construction & Development's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. For instance, we've identified 4 warning signs for Founding Construction & Development (2 are a bit unpleasant) you should be aware of.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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