Is Formosa Sumco Technology (TWSE:3532) Using Too Much Debt?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies Formosa Sumco Technology Corporation (TWSE:3532) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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 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. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Formosa Sumco Technology

How Much Debt Does Formosa Sumco Technology Carry?

As you can see below, at the end of September 2024, Formosa Sumco Technology had NT$18.4b of debt, up from NT$4.43b a year ago. Click the image for more detail. However, it also had NT$3.44b in cash, and so its net debt is NT$14.9b.

A Look At Formosa Sumco Technology's Liabilities

We can see from the most recent balance sheet that Formosa Sumco Technology had liabilities of NT$11.0b falling due within a year, and liabilities of NT$15.9b due beyond that. Offsetting these obligations, it had cash of NT$3.44b as well as receivables valued at NT$1.89b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$21.5b.

This deficit isn't so bad because Formosa Sumco Technology is worth NT$40.9b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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

Formosa Sumco Technology has a debt to EBITDA ratio of 3.3, which signals significant debt, but is still pretty reasonable for most types of business. However, its interest coverage of 45.8 is very high, suggesting that the interest expense on the debt is currently quite low. Shareholders should be aware that Formosa Sumco Technology's EBIT was down 52% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Formosa Sumco Technology 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Formosa Sumco Technology saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

On the face of it, Formosa Sumco Technology's conversion of EBIT to free cash flow left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its interest cover is a good sign, and makes us more optimistic. We're quite clear that we consider Formosa Sumco Technology to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 4 warning signs for Formosa Sumco Technology you should be aware of, and 3 of them make us uncomfortable.

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. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.