Is Wah Lee Industrial (TPE:3010) Using Too Much Debt?

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.' 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 Wah Lee Industrial Corp. (TPE:3010) 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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth 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.

Check out our latest analysis for Wah Lee Industrial

What Is Wah Lee Industrial's Net Debt?

The image below, which you can click on for greater detail, shows that Wah Lee Industrial had debt of NT$10.9b at the end of September 2020, a reduction from NT$11.7b over a year. However, it does have NT$3.63b in cash offsetting this, leading to net debt of about NT$7.25b.

How Healthy Is Wah Lee Industrial's Balance Sheet?

The latest balance sheet data shows that Wah Lee Industrial had liabilities of NT$15.6b due within a year, and liabilities of NT$6.19b falling due after that. Offsetting these obligations, it had cash of NT$3.63b as well as receivables valued at NT$16.7b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$1.40b.

Of course, Wah Lee Industrial has a market capitalization of NT$17.9b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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

Wah Lee Industrial 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 11.9 is very high, suggesting that the interest expense on the debt is currently quite low. We note that Wah Lee Industrial grew its EBIT by 26% in the last year, and that should make it easier to pay down debt, going forward. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Wah Lee Industrial's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Wah Lee Industrial created free cash flow amounting to 14% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

Wah Lee Industrial's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But truth be told we feel its conversion of EBIT to free cash flow does undermine this impression a bit. Looking at all the aforementioned factors together, it strikes us that Wah Lee Industrial can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Consider for instance, the ever-present spectre of investment risk. We've identified 3 warning signs with Wah Lee Industrial , and understanding them should be part of your investment process.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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