Here's Why Ruentex DevelopmentLtd (TPE:9945) 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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Ruentex Development Co.,Ltd. (TPE:9945) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Ruentex DevelopmentLtd

What Is Ruentex DevelopmentLtd's Debt?

The chart below, which you can click on for greater detail, shows that Ruentex DevelopmentLtd had NT$44.6b in debt in December 2020; about the same as the year before. However, it does have NT$4.71b in cash offsetting this, leading to net debt of about NT$39.8b.

A Look At Ruentex DevelopmentLtd's Liabilities

We can see from the most recent balance sheet that Ruentex DevelopmentLtd had liabilities of NT$24.8b falling due within a year, and liabilities of NT$42.6b due beyond that. Offsetting this, it had NT$4.71b in cash and NT$3.71b in receivables that were due within 12 months. So it has liabilities totalling NT$59.0b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of NT$74.4b, so it does suggest shareholders should keep an eye on Ruentex DevelopmentLtd's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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). 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 12.9, it's fair to say Ruentex DevelopmentLtd does have a significant amount of debt. But the good news is that it boasts fairly comforting interest cover of 3.3 times, suggesting it can responsibly service its obligations. Fortunately, Ruentex DevelopmentLtd grew its EBIT by 9.9% in the last year, slowly shrinking its debt relative to earnings. There's no doubt that we learn most about debt from the balance sheet. But it is Ruentex DevelopmentLtd'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Ruentex DevelopmentLtd generated free cash flow amounting to a very robust 86% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Our View

Ruentex DevelopmentLtd's net debt to EBITDA and interest cover definitely weigh on it, in our esteem. But the good news is it seems to be able to convert EBIT to free cash flow with ease. We think that Ruentex DevelopmentLtd'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. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of Ruentex DevelopmentLtd's earnings per share history for free.

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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