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.’ 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. We note that Daqo New Energy Corp. (NYSE:DQ) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Daqo New Energy’s Net Debt?
The image below, which you can click on for greater detail, shows that Daqo New Energy had debt of US$222.2m at the end of March 2021, a reduction from US$265.6m over a year. On the flip side, it has US$174.7m in cash leading to net debt of about US$47.5m.
A Look At Daqo New Energy’s Liabilities
The latest balance sheet data shows that Daqo New Energy had liabilities of US$347.6m due within a year, and liabilities of US$206.3m falling due after that. Offsetting these obligations, it had cash of US$174.7m as well as receivables valued at US$38.6m due within 12 months. So it has liabilities totalling US$340.6m more than its cash and near-term receivables, combined.
Given Daqo New Energy has a market capitalization of US$3.95b, it’s hard to believe these liabilities pose much threat. Having said that, it’s clear that we should continue to monitor its balance sheet, lest it change for the worse. But either way, Daqo New Energy has virtually no net debt, so it’s fair to say it does not have a heavy debt load!
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Daqo New Energy has net debt of just 0.15 times EBITDA, indicating that it is certainly not a reckless borrower. And it boasts interest cover of 9.3 times, which is more than adequate. Even more impressive was the fact that Daqo New Energy grew its EBIT by 199% over twelve months. 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 ultimately the future profitability of the business will decide if Daqo New Energy can strengthen its balance sheet over time.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it’s worth checking how much of that EBIT is backed by free cash flow. In the last three years, Daqo New Energy basically broke even on a free cash flow basis. While many companies do operate at break-even, we prefer see substantial free cash flow, especially if a it already has dead.
Our View
Daqo New Energy’s EBIT growth rate suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14’s goalkeeper. But the stark truth is that we are concerned by its conversion of EBIT to free cash flow. When we consider the range of factors above, it looks like Daqo New Energy is pretty sensible with its use of debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. There’s no doubt that we learn most about debt from the balance sheet.