Does Cheng Uei Precision Industry (TPE:2392) Have A Healthy Balance Sheet?

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. We can see that Cheng Uei Precision Industry Co., Ltd. (TPE:2392) does use debt in its business. 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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Cheng Uei Precision Industry

What Is Cheng Uei Precision Industry's Net Debt?

As you can see below, at the end of December 2020, Cheng Uei Precision Industry had NT$24.1b of debt, up from NT$18.3b a year ago. Click the image for more detail. On the flip side, it has NT$11.8b in cash leading to net debt of about NT$12.3b.

How Strong Is Cheng Uei Precision Industry's Balance Sheet?

According to the last reported balance sheet, Cheng Uei Precision Industry had liabilities of NT$30.3b due within 12 months, and liabilities of NT$21.9b due beyond 12 months. Offsetting this, it had NT$11.8b in cash and NT$17.3b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$23.0b.

Given this deficit is actually higher than the company's market capitalization of NT$22.7b, we think shareholders really should watch Cheng Uei Precision Industry's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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 debt to EBITDA ratio of 2.3, Cheng Uei Precision Industry uses debt artfully but responsibly. And the alluring interest cover (EBIT of 9.8 times interest expense) certainly does not do anything to dispel this impression. We saw Cheng Uei Precision Industry grow its EBIT by 5.0% in the last twelve months. Whilst that hardly knocks our socks off it is a positive when it comes to debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is Cheng Uei Precision Industry'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. In the last three years, Cheng Uei Precision Industry's free cash flow amounted to 43% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

Neither Cheng Uei Precision Industry's ability to handle its total liabilities nor its net debt to EBITDA gave us confidence in its ability to take on more debt. But its interest cover tells a very different story, and suggests some resilience. Taking the abovementioned factors together we do think Cheng Uei Precision Industry's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. For instance, we've identified 2 warning signs for Cheng Uei Precision Industry that you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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