Farglory Free Trade Zone Investment Holding (TPE:5607) Takes On Some Risk With Its Use Of Debt

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. Importantly, Farglory Free Trade Zone Investment Holding Co., Ltd (TPE:5607) does carry debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. If things get really bad, the lenders can take control of the business. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Farglory Free Trade Zone Investment Holding

What Is Farglory Free Trade Zone Investment Holding's Debt?

As you can see below, at the end of September 2020, Farglory Free Trade Zone Investment Holding had NT$2.42b of debt, up from NT$1.91b a year ago. Click the image for more detail. However, because it has a cash reserve of NT$2.40b, its net debt is less, at about NT$21.8m.

How Strong Is Farglory Free Trade Zone Investment Holding's Balance Sheet?

We can see from the most recent balance sheet that Farglory Free Trade Zone Investment Holding had liabilities of NT$1.14b falling due within a year, and liabilities of NT$6.09b due beyond that. Offsetting this, it had NT$2.40b in cash and NT$186.5m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$4.64b.

This is a mountain of leverage relative to its market capitalization of NT$6.12b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry. But either way, Farglory Free Trade Zone Investment Holding has virtually no net debt, so it's fair to say it does not have a heavy debt load!

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). 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).

With net debt at just 0.026 times EBITDA, it seems Farglory Free Trade Zone Investment Holding only uses a little bit of leverage. But EBIT was only 6.9 times the interest expense last year, so the borrowing is clearly weighing on the business somewhat. In fact Farglory Free Trade Zone Investment Holding's saving grace is its low debt levels, because its EBIT has tanked 37% in the last twelve months. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Farglory Free Trade Zone Investment Holding'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Farglory Free Trade Zone Investment Holding's free cash flow amounted to 39% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

Mulling over Farglory Free Trade Zone Investment Holding's attempt at (not) growing its EBIT, we're certainly not enthusiastic. But on the bright side, its net debt to EBITDA is a good sign, and makes us more optimistic. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Farglory Free Trade Zone Investment Holding stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example - Farglory Free Trade Zone Investment Holding has 1 warning sign we think 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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This article by Simply Wall St is general in nature. 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.
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