Is Chang Wah Electromaterials (TPE:8070) 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. As with many other companies Chang Wah Electromaterials Inc. (TPE:8070) makes use of debt. But the real question is whether this debt is making the company risky.

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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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 Chang Wah Electromaterials

What Is Chang Wah Electromaterials's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Chang Wah Electromaterials had NT$10.1b of debt, an increase on NT$5.37b, over one year. On the flip side, it has NT$3.94b in cash leading to net debt of about NT$6.14b.

How Healthy Is Chang Wah Electromaterials's Balance Sheet?

We can see from the most recent balance sheet that Chang Wah Electromaterials had liabilities of NT$7.74b falling due within a year, and liabilities of NT$6.20b due beyond that. On the other hand, it had cash of NT$3.94b and NT$3.64b worth of receivables due within a year. So its liabilities total NT$6.37b more than the combination of its cash and short-term receivables.

Chang Wah Electromaterials has a market capitalization of NT$14.9b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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.

Chang Wah Electromaterials has a debt to EBITDA ratio of 3.3, which signals significant debt, but is still pretty reasonable for most types of business. But its EBIT was about 1k times its interest expense, implying the company isn't really paying a high cost to maintain that level of debt. Even were the low cost to prove unsustainable, that is a good sign. If Chang Wah Electromaterials can keep growing EBIT at last year's rate of 12% over the last year, then it will find its debt load easier to manage. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Chang Wah Electromaterials'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 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, Chang Wah Electromaterials recorded free cash flow worth a fulsome 87% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Our View

The good news is that Chang Wah Electromaterials'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 net debt to EBITDA does undermine this impression a bit. Taking all this data into account, it seems to us that Chang Wah Electromaterials takes a pretty sensible approach to debt. While that brings some risk, it can also enhance returns for shareholders. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Like risks, for instance. Every company has them, and we've spotted 2 warning signs for Chang Wah Electromaterials (of which 1 is a bit concerning!) you should know about.

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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