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 Great Wall Enterprise Co., Ltd. (TPE:1210) does use debt in its business. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Great Wall Enterprise’s Debt?
The chart below, which you can click on for greater detail, shows that Great Wall Enterprise had NT$14.3b in debt in September 2020; about the same as the year before. However, it also had NT$5.29b in cash, and so its net debt is NT$9.00b.
How Strong Is Great Wall Enterprise’s Balance Sheet?
The latest balance sheet data shows that Great Wall Enterprise had liabilities of NT$21.9b due within a year, and liabilities of NT$3.31b falling due after that. On the other hand, it had cash of NT$5.29b and NT$6.26b worth of receivables due within a year. So its liabilities total NT$13.7b more than the combination of its cash and short-term receivables.
Great Wall Enterprise has a market capitalization of NT$39.9b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
We’d say that Great Wall Enterprise’s moderate net debt to EBITDA ratio ( being 1.5), indicates prudence when it comes to debt. And its strong interest cover of 50.8 times, makes us even more comfortable. In addition to that, we’re happy to report that Great Wall Enterprise has boosted its EBIT by 34%, thus reducing the spectre of future debt repayments. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Great Wall Enterprise can strengthen its balance sheet over time. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.
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. In the last three years, Great Wall Enterprise’s free cash flow amounted to 27% of its EBIT, less than we’d expect. That’s not great, when it comes to paying down debt.
Happily, Great Wall Enterprise’s impressive interest cover implies it has the upper hand on its debt. But, on a more sombre note, we are a little concerned by its conversion of EBIT to free cash flow. All these things considered, it appears that Great Wall Enterprise can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it’s worth keeping an eye on this one. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet – far from it. To that end, you should be aware of the 2 warning signs we’ve spotted with Great Wall Enterprise .
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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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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