The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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. As with many other companies First Steamship Co., Ltd. (TPE:2601) makes use of debt. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does First Steamship Carry?
As you can see below, at the end of December 2020, First Steamship had NT$12.1b of debt, up from NT$10.8b a year ago. Click the image for more detail. On the flip side, it has NT$4.20b in cash leading to net debt of about NT$7.94b.
How Strong Is First Steamship's Balance Sheet?
According to the last reported balance sheet, First Steamship had liabilities of NT$13.6b due within 12 months, and liabilities of NT$10.7b due beyond 12 months. On the other hand, it had cash of NT$4.20b and NT$935.3m worth of receivables due within a year. So its liabilities total NT$19.2b more than the combination of its cash and short-term receivables.
The deficiency here weighs heavily on the NT$6.93b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. At the end of the day, First Steamship would probably need a major re-capitalization if its creditors were to demand repayment.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
First Steamship shareholders face the double whammy of a high net debt to EBITDA ratio (6.7), and fairly weak interest coverage, since EBIT is just 0.44 times the interest expense. The debt burden here is substantial. Worse, First Steamship's EBIT was down 78% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since First Steamship will need earnings to service that debt. 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. Considering the last three years, First Steamship actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.
On the face of it, First Steamship's EBIT growth rate left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. And even its net debt to EBITDA fails to inspire much confidence. It looks to us like First Steamship carries a significant balance sheet burden. If you harvest honey without a bee suit, you risk getting stung, so we'd probably stay away from this particular stock. Even though First Steamship lost money on the bottom line, its positive EBIT suggests the business itself has potential. So you might want to check out how earnings have been trending over the last few years.
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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