Stock Analysis

Far Eastern Department Stores (TPE:2903) Takes On Some Risk With Its Use Of Debt

TWSE:2903
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David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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. Importantly, Far Eastern Department Stores, Ltd. (TPE:2903) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. If things get really bad, the lenders can take control of the business. 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, 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Far Eastern Department Stores

What Is Far Eastern Department Stores's Debt?

The image below, which you can click on for greater detail, shows that Far Eastern Department Stores had debt of NT$28.2b at the end of September 2020, a reduction from NT$30.8b over a year. However, it does have NT$9.53b in cash offsetting this, leading to net debt of about NT$18.6b.

debt-equity-history-analysis
TSEC:2903 Debt to Equity History January 8th 2021

A Look At Far Eastern Department Stores' Liabilities

According to the last reported balance sheet, Far Eastern Department Stores had liabilities of NT$42.4b due within 12 months, and liabilities of NT$42.1b due beyond 12 months. Offsetting these obligations, it had cash of NT$9.53b as well as receivables valued at NT$1.43b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$73.6b.

The deficiency here weighs heavily on the NT$32.6b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. After all, Far Eastern Department Stores would likely require a major re-capitalisation if it had to pay its creditors today.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

With net debt to EBITDA of 3.1 Far Eastern Department Stores has a fairly noticeable amount of debt. On the plus side, its EBIT was 8.4 times its interest expense, and its net debt to EBITDA, was quite high, at 3.1. Unfortunately, Far Eastern Department Stores's EBIT flopped 13% over the last four quarters. If that sort of decline is not arrested, then the managing its debt will be harder than selling broccoli flavoured ice-cream for a premium. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Far Eastern Department Stores'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 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, Far Eastern Department Stores actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

Mulling over Far Eastern Department Stores's attempt at staying on top of its total liabilities, we're certainly not enthusiastic. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Looking at the bigger picture, it seems clear to us that Far Eastern Department Stores's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Be aware that Far Eastern Department Stores is showing 3 warning signs in our investment analysis , you should know about...

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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