Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that ‘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. As with many other companies SuperAlloy Industrial Co., Ltd. (GTSM:1563) makes use of debt. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company’s use of debt, we first look at cash and debt together.
What Is SuperAlloy Industrial’s Net Debt?
As you can see below, SuperAlloy Industrial had NT$8.24b of debt, at December 2020, which is about the same as the year before. You can click the chart for greater detail. However, it does have NT$1.25b in cash offsetting this, leading to net debt of about NT$6.99b.
How Strong Is SuperAlloy Industrial’s Balance Sheet?
The latest balance sheet data shows that SuperAlloy Industrial had liabilities of NT$3.39b due within a year, and liabilities of NT$6.19b falling due after that. Offsetting these obligations, it had cash of NT$1.25b as well as receivables valued at NT$821.6m due within 12 months. So it has liabilities totalling NT$7.51b more than its cash and near-term receivables, combined.
This deficit isn’t so bad because SuperAlloy Industrial 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.
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).
SuperAlloy Industrial has a rather high debt to EBITDA ratio of 5.4 which suggests a meaningful debt load. However, its interest coverage of 5.0 is reasonably strong, which is a good sign. Shareholders should be aware that SuperAlloy Industrial’s EBIT was down 49% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. The balance sheet is clearly the area to focus on when you are analysing debt. But it is SuperAlloy Industrial’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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, SuperAlloy Industrial 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.
To be frank both SuperAlloy Industrial’s net debt to EBITDA and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. Having said that, its ability to cover its interest expense with its EBIT isn’t such a worry. We’re quite clear that we consider SuperAlloy Industrial to be really rather risky, as a result of its balance sheet health. For this reason we’re pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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 SuperAlloy Industrial (2 are a bit concerning) 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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