Shan-Loong TransportationLtd (TPE:2616) Seems To Use Debt Quite Sensibly

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. Importantly, Shan-Loong Transportation Co.,Ltd (TPE:2616) does carry debt. But should shareholders be worried about its use of debt?

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. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Shan-Loong TransportationLtd

How Much Debt Does Shan-Loong TransportationLtd Carry?

As you can see below, at the end of September 2020, Shan-Loong TransportationLtd had NT$1.21b of debt, up from NT$1.16b a year ago. Click the image for more detail. However, it also had NT$1.16b in cash, and so its net debt is NT$51.3m.

How Strong Is Shan-Loong TransportationLtd's Balance Sheet?

The latest balance sheet data shows that Shan-Loong TransportationLtd had liabilities of NT$2.00b due within a year, and liabilities of NT$2.56b falling due after that. Offsetting this, it had NT$1.16b in cash and NT$927.5m in receivables that were due within 12 months. So its liabilities total NT$2.47b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Shan-Loong TransportationLtd has a market capitalization of NT$4.27b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. But either way, Shan-Loong TransportationLtd has virtually no net debt, so it's fair to say it does not have a heavy debt load!

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).

Shan-Loong TransportationLtd has very modest net debt levels, with net debt at just 0.083 times EBITDA. Humorously, it actually received more in interest over the last twelve months than it had to pay. So it's fair to say it can handle debt like an Olympic ice-skater handles a pirouette. Even more impressive was the fact that Shan-Loong TransportationLtd grew its EBIT by 134% over twelve months. If maintained that growth will make the debt even more manageable in the years ahead. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Shan-Loong TransportationLtd 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Shan-Loong TransportationLtd recorded free cash flow worth 69% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

The good news is that Shan-Loong TransportationLtd's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But truth be told we feel its level of total liabilities does undermine this impression a bit. Looking at the bigger picture, we think Shan-Loong TransportationLtd's use of debt seems quite reasonable and we're not concerned about it. After all, sensible leverage can boost returns on equity. 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. Be aware that Shan-Loong TransportationLtd is showing 2 warning signs in our investment analysis , and 1 of those is concerning...

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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