Is Taiwan Cogeneration (TPE:8926) A Risky Investment?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Taiwan Cogeneration Corporation (TPE:8926) does use debt in its business. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Taiwan Cogeneration

What Is Taiwan Cogeneration's Net Debt?

As you can see below, at the end of December 2020, Taiwan Cogeneration had NT$5.58b of debt, up from NT$4.62b a year ago. Click the image for more detail. On the flip side, it has NT$1.60b in cash leading to net debt of about NT$3.97b.

A Look At Taiwan Cogeneration's Liabilities

The latest balance sheet data shows that Taiwan Cogeneration had liabilities of NT$4.85b due within a year, and liabilities of NT$5.94b falling due after that. On the other hand, it had cash of NT$1.60b and NT$4.56b worth of receivables due within a year. So it has liabilities totalling NT$4.63b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Taiwan Cogeneration is worth NT$22.7b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

As it happens Taiwan Cogeneration has a fairly concerning net debt to EBITDA ratio of 6.7 but very strong interest coverage of 11.7. So either it has access to very cheap long term debt or that interest expense is going to grow! Importantly, Taiwan Cogeneration grew its EBIT by 59% over the last twelve months, and that growth will make it easier to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But it is Taiwan Cogeneration'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Taiwan Cogeneration actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

Taiwan Cogeneration's conversion of EBIT to free cash flow suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But the stark truth is that we are concerned by its net debt to EBITDA. Zooming out, Taiwan Cogeneration seems to use debt quite reasonably; and that gets the nod from us. While debt does bring risk, when used wisely it can also bring a higher return on equity. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 2 warning signs for Taiwan Cogeneration you should be aware of.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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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