Here's Why Impro Precision Industries (HKG:1286) Can Manage Its Debt Responsibly

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Impro Precision Industries Limited (HKG:1286) does carry debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out the opportunities and risks within the HK Machinery industry.

What Is Impro Precision Industries's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2022 Impro Precision Industries had HK$1.86b of debt, an increase on HK$920.8m, over one year. However, it does have HK$751.7m in cash offsetting this, leading to net debt of about HK$1.11b.

How Healthy Is Impro Precision Industries' Balance Sheet?

According to the last reported balance sheet, Impro Precision Industries had liabilities of HK$1.78b due within 12 months, and liabilities of HK$1.23b due beyond 12 months. Offsetting this, it had HK$751.7m in cash and HK$1.24b in receivables that were due within 12 months. So it has liabilities totalling HK$1.01b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Impro Precision Industries has a market capitalization of HK$4.26b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).

Impro Precision Industries's net debt is only 1.1 times its EBITDA. And its EBIT easily covers its interest expense, being 20.0 times the size. So we're pretty relaxed about its super-conservative use of debt. On top of that, Impro Precision Industries grew its EBIT by 31% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Impro Precision Industries's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Impro Precision Industries created free cash flow amounting to 11% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

Happily, Impro Precision Industries's impressive interest cover implies it has the upper hand on its debt. But we must concede we find its conversion of EBIT to free cash flow has the opposite effect. All these things considered, it appears that Impro Precision Industries can comfortably handle its current debt levels. 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. To that end, you should be aware of the 1 warning sign we've spotted with Impro Precision Industries .

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.