We Think Tai Tung Communication (TWSE:8011) Is Taking Some Risk With Its 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.' 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. Importantly, Tai Tung Communication Co., Ltd. (TWSE:8011) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Tai Tung Communication

What Is Tai Tung Communication's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2023 Tai Tung Communication had NT$3.39b of debt, an increase on NT$2.48b, over one year. However, it also had NT$977.7m in cash, and so its net debt is NT$2.41b.

A Look At Tai Tung Communication's Liabilities

The latest balance sheet data shows that Tai Tung Communication had liabilities of NT$1.28b due within a year, and liabilities of NT$2.78b falling due after that. On the other hand, it had cash of NT$977.7m and NT$600.6m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$2.49b.

This is a mountain of leverage relative to its market capitalization of NT$4.07b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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

Weak interest cover of 0.82 times and a disturbingly high net debt to EBITDA ratio of 6.6 hit our confidence in Tai Tung Communication like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. One redeeming factor for Tai Tung Communication is that it turned last year's EBIT loss into a gain of NT$54m, over the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Tai Tung Communication'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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Tai Tung Communication 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

To be frank both Tai Tung Communication's interest cover and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But at least its EBIT growth rate is not so bad. We're quite clear that we consider Tai Tung Communication 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. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 4 warning signs for Tai Tung Communication (of which 2 shouldn't be ignored!) you should know about.

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.