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

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that Impro Precision Industries Limited (HKG:1286) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. If things get really bad, the lenders can take control of the business. 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. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Impro Precision Industries

What Is Impro Precision Industries's Net Debt?

As you can see below, at the end of June 2023, Impro Precision Industries had HK$2.24b of debt, up from HK$1.86b a year ago. Click the image for more detail. However, it does have HK$605.1m in cash offsetting this, leading to net debt of about HK$1.63b.

A Look At Impro Precision Industries' Liabilities

We can see from the most recent balance sheet that Impro Precision Industries had liabilities of HK$1.97b falling due within a year, and liabilities of HK$1.48b due beyond that. On the other hand, it had cash of HK$605.1m and HK$1.32b worth of receivables due within a year. So it has liabilities totalling HK$1.53b more than its cash and near-term receivables, combined.

Impro Precision Industries has a market capitalization of HK$3.94b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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).

With net debt sitting at just 1.4 times EBITDA, Impro Precision Industries is arguably pretty conservatively geared. And this view is supported by the solid interest coverage, with EBIT coming in at 8.7 times the interest expense over the last year. And we also note warmly that Impro Precision Industries grew its EBIT by 15% last year, making its debt load easier to handle. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Impro Precision Industries can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. 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 3.8% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

Based on what we've seen Impro Precision Industries is not finding it easy, given its conversion of EBIT to free cash flow, but the other factors we considered give us cause to be optimistic. In particular, we thought its interest cover was a positive. When we consider all the factors mentioned above, we do feel a bit cautious about Impro Precision Industries's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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 example, we've discovered 1 warning sign for Impro Precision Industries that you should be aware of before investing here.

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.