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 seems the smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess how risky a company is. We can see that Nan Liu Enterprise Co., Ltd. (TPE:6504) does use debt in its business. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company’s debt levels is to consider its cash and debt together.
What Is Nan Liu Enterprise’s Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of September 2020 Nan Liu Enterprise had NT$4.52b of debt, an increase on NT$4.23b, over one year. However, it does have NT$2.04b in cash offsetting this, leading to net debt of about NT$2.49b.
How Strong Is Nan Liu Enterprise’s Balance Sheet?
The latest balance sheet data shows that Nan Liu Enterprise had liabilities of NT$3.59b due within a year, and liabilities of NT$3.41b falling due after that. Offsetting these obligations, it had cash of NT$2.04b as well as receivables valued at NT$1.63b due within 12 months. So its liabilities total NT$3.33b more than the combination of its cash and short-term receivables.
This deficit isn’t so bad because Nan Liu Enterprise is worth NT$14.0b, 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.
Nan Liu Enterprise’s net debt is only 1.2 times its EBITDA. And its EBIT covers its interest expense a whopping 211 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Better yet, Nan Liu Enterprise grew its EBIT by 140% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Nan Liu Enterprise’s ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Nan Liu Enterprise barely recorded positive free cash flow, in total. Some might say that’s a concern, when it comes considering how easily it would be for it to down debt.
The good news is that Nan Liu Enterprise’s demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But we must concede we find its conversion of EBIT to free cash flow has the opposite effect. Looking at all the aforementioned factors together, it strikes us that Nan Liu Enterprise can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it’s worth monitoring the balance sheet. 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. Take risks, for example – Nan Liu Enterprise has 3 warning signs we think you should be aware of.
If, after all that, you’re more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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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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