These 4 Measures Indicate That Impro Precision Industries (HKG:1286) Is Using Debt Reasonably Well

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Impro Precision Industries Limited (HKG:1286) makes use of debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Impro Precision Industries

What Is Impro Precision Industries's Debt?

You can click the graphic below for the historical numbers, but it shows that Impro Precision Industries had HK$839.5m of debt in June 2020, down from HK$1.89b, one year before. However, it does have HK$559.2m in cash offsetting this, leading to net debt of about HK$280.3m.

A Look At Impro Precision Industries's Liabilities

Zooming in on the latest balance sheet data, we can see that Impro Precision Industries had liabilities of HK$1.03b due within 12 months and liabilities of HK$539.6m due beyond that. Offsetting these obligations, it had cash of HK$559.2m as well as receivables valued at HK$662.8m due within 12 months. So its liabilities total HK$352.6m more than the combination of its cash and short-term receivables.

Given Impro Precision Industries has a market capitalization of HK$4.97b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Impro Precision Industries has a low net debt to EBITDA ratio of only 0.34. And its EBIT easily covers its interest expense, being 23.5 times the size. So we're pretty relaxed about its super-conservative use of debt. In fact Impro Precision Industries's saving grace is its low debt levels, because its EBIT has tanked 32% in the last twelve months. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. The balance sheet is clearly the area to focus on when you are analysing debt. 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 it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Impro Precision Industries produced sturdy free cash flow equating to 66% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

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 EBIT growth rate has the opposite effect. All these things considered, it appears that Impro Precision Industries can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Impro Precision Industries is showing 1 warning sign in our investment analysis , you should know about...

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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