Is Transtech Optelecom Science Holdings (HKG:9963) Using Too Much Debt?

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.' 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. We note that Transtech Optelecom Science Holdings Limited (HKG:9963) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

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. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Transtech Optelecom Science Holdings

What Is Transtech Optelecom Science Holdings's Net Debt?

As you can see below, at the end of June 2021, Transtech Optelecom Science Holdings had HK$57.8m of debt, up from HK$16.8m a year ago. Click the image for more detail. However, it also had HK$8.06m in cash, and so its net debt is HK$49.8m.

How Strong Is Transtech Optelecom Science Holdings' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Transtech Optelecom Science Holdings had liabilities of HK$80.9m due within 12 months and liabilities of HK$3.19m due beyond that. Offsetting this, it had HK$8.06m in cash and HK$325.2m in receivables that were due within 12 months. So it can boast HK$249.2m more liquid assets than total liabilities.

This surplus liquidity suggests that Transtech Optelecom Science Holdings' balance sheet could take a hit just as well as Homer Simpson's head can take a punch. On this view, lenders should feel as safe as the beloved of a black-belt karate master.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

With a net debt to EBITDA ratio of 6.9, it's fair to say Transtech Optelecom Science Holdings does have a significant amount of debt. However, its interest coverage of 5.8 is reasonably strong, which is a good sign. Shareholders should be aware that Transtech Optelecom Science Holdings's EBIT was down 83% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Transtech Optelecom Science Holdings will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

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. Over the last three years, Transtech Optelecom Science Holdings saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

Neither Transtech Optelecom Science Holdings's ability to grow its EBIT nor its conversion of EBIT to free cash flow gave us confidence in its ability to take on more debt. But its level of total liabilities tells a very different story, and suggests some resilience. Looking at all the angles mentioned above, it does seem to us that Transtech Optelecom Science Holdings is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. 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 Transtech Optelecom Science Holdings is showing 2 warning signs in our investment analysis , and 1 of those shouldn't be ignored...

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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.

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