David Iben put it well when he said, ‘Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.’ 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. As with many other companies Horng Tong Enterprise Co., Ltd. (GTSM:5271) makes use of debt. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Horng Tong Enterprise’s Net Debt?
The image below, which you can click on for greater detail, shows that Horng Tong Enterprise had debt of NT$208.8m at the end of June 2020, a reduction from NT$230.4m over a year. On the flip side, it has NT$82.6m in cash leading to net debt of about NT$126.2m.
A Look At Horng Tong Enterprise’s Liabilities
According to the last reported balance sheet, Horng Tong Enterprise had liabilities of NT$534.8m due within 12 months, and liabilities of NT$65.2m due beyond 12 months. On the other hand, it had cash of NT$82.6m and NT$312.0m worth of receivables due within a year. So its liabilities total NT$205.4m more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since Horng Tong Enterprise has a market capitalization of NT$382.2m, and so it could probably strengthen its balance sheet by raising capital if it needed to. 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). 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).
Horng Tong Enterprise’s net debt is sitting at a very reasonable 2.4 times its EBITDA, while its EBIT covered its interest expense just 3.3 times last year. While that doesn’t worry us too much, it does suggest the interest payments are somewhat of a burden. One redeeming factor for Horng Tong Enterprise is that it turned last year’s EBIT loss into a gain of NT$30m, over the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But it is Horng Tong Enterprise’s earnings that will influence how the balance sheet holds up in the future. So if you’re keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it’s worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. During the last year, Horng Tong Enterprise burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
Mulling over Horng Tong Enterprise’s attempt at converting EBIT to free cash flow, we’re certainly not enthusiastic. Having said that, its ability to grow its EBIT isn’t such a worry. Looking at the bigger picture, it seems clear to us that Horng Tong Enterprise’s use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. 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. For instance, we’ve identified 5 warning signs for Horng Tong Enterprise that 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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