Legendary fund manager Li Lu (whom Charlie Munger supported) once said, “The biggest risk in investing is not price volatility, but whether you will suffer a permanent loss of capital. When we think about the risk level of a business, we always like to look at its use of debt because debt overload can lead to bankruptcy. Mostly, Fortune Electric Co., Ltd. (TPE: 1519) is in debt. But does this debt worry shareholders?
Why is debt risky?
Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, it exists at their mercy. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are ruthlessly liquidated by their bankers. However, a more common (but still costly) situation is where a company has to dilute its shareholders at a cheap stock price just to get its debt under control. Of course, many companies use debt to finance growth without any negative consequences. The first step in examining a company’s debt levels is to consider its cash flow and debt together.
Check out our latest analysis for Fortune Electric
What is Fortune Electric’s debt?
The image below, which you can click for more details, shows that as of December 2020, Fortune Electric was in debt of NT $ 1.31 billion, compared to NT $ 1.19 billion in one year. On the other hand, he has NT $ 170.8 million in cash, which leads to net debt of around NT $ 1.14 billion.
How healthy is Fortune Electric’s balance sheet?
Zooming in on the latest balance sheet data, we can see that Fortune Electric had NT $ 3.93 billion liabilities due within 12 months and NT $ 1.21 billion liabilities beyond. On the other hand, he had cash of NT $ 170.8 million and NT $ 3.31 billion in receivables due within the year. It therefore has liabilities totaling NT $ 1.66 billion more than its cash and short-term receivables combined.
Of course, Fortune Electric has a market cap of NT $ 13.1 billion, so these liabilities are probably manageable. Having said that, it is clear that we must continue to monitor his record lest it get worse.
We measure a company’s indebtedness relative to its earning power by looking at its net debt divided by its earnings before interest, taxes, depreciation, and amortization (EBITDA) and calculating the ease with which its earnings before interest and taxes (EBIT ) cover his interests. costs (interest coverage). The advantage of this approach is that we take into account both the absolute quantum of the debt (with net debt over EBITDA) and the actual interest charges associated with that debt (with its interest coverage ratio).
We would say Fortune Electric’s moderate net debt to EBITDA ratio (or 2.0) indicates leverage conservatism. And its 18.5x high interest coverage makes us even more comfortable. Importantly, Fortune Electric has increased its EBIT by 43% over the past twelve months, and this growth will make it easier to manage its debt. When analyzing debt levels, the balance sheet is the obvious starting point. But ultimately, the company’s future profitability will decide whether Fortune Electric can strengthen its balance sheet over time. So if you are focused on the future you can check out this free report showing analysts’ earnings forecasts.
Finally, a business needs free cash flow to repay its debt; accounting profits do not reduce it. The logical step is therefore to examine the proportion of this EBIT that corresponds to the actual free cash flow. Fortunately for all shareholders, Fortune Electric has actually produced more free cash flow than EBIT over the past three years. This kind of big cash conversion turns us on as much as the crowd when the beat drops at a Daft Punk concert.
Our point of view
Fortunately, Fortune Electric’s impressive interest coverage means it has the upper hand on its debt. And that’s just the start of the good news as its conversion from EBIT to free cash flow is also very encouraging. Given this array of factors, it seems to us that Fortune Electric is fairly conservative with its debt, and the risks appear to be well managed. We are therefore not worried about the use of a small leverage effect on the balance sheet. When analyzing debt levels, the balance sheet is the obvious starting point. But at the end of the day, every business can contain risks that exist off the balance sheet. For example, we discovered 1 warning sign for Fortune Electric which you should be aware of before investing here.
At the end of the day, sometimes it’s easier to focus on businesses that don’t even need debt. Readers can access a list of growth stocks with zero net debt 100% free, at present.
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