Is Darfon Electronics (TPE:8163) Using Too Much Debt?

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 note that Darfon Electronics Corp. (TPE:8163) does have debt on its balance sheet. But is this debt a concern to shareholders?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Darfon Electronics

What Is Darfon Electronics's Net Debt?

As you can see below, at the end of September 2020, Darfon Electronics had NT$4.29b of debt, up from NT$3.86b a year ago. Click the image for more detail. However, it also had NT$2.66b in cash, and so its net debt is NT$1.62b.

How Healthy Is Darfon Electronics's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Darfon Electronics had liabilities of NT$11.5b due within 12 months and liabilities of NT$1.64b due beyond that. Offsetting these obligations, it had cash of NT$2.66b as well as receivables valued at NT$6.87b due within 12 months. So it has liabilities totalling NT$3.57b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Darfon Electronics has a market capitalization of NT$12.1b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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).

Darfon Electronics has net debt of just 0.98 times EBITDA, suggesting it could ramp leverage without breaking a sweat. But the really cool thing is that it actually managed to receive more interest than it paid, over the last year. So it's fair to say it can handle debt like a hotshot teppanyaki chef handles cooking. On the other hand, Darfon Electronics's EBIT dived 14%, over the last year. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. There's no doubt that we learn most about debt from the balance sheet. But it is Darfon Electronics'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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, Darfon Electronics recorded free cash flow worth 69% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

When it comes to the balance sheet, the standout positive for Darfon Electronics was the fact that it seems able to cover its interest expense with its EBIT confidently. However, our other observations weren't so heartening. To be specific, it seems about as good at (not) growing its EBIT as wet socks are at keeping your feet warm. When we consider all the elements mentioned above, it seems to us that Darfon Electronics is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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. For instance, we've identified 2 warning signs for Darfon Electronics that you should be aware of.

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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