Here's Why Genetec Technology Berhad (KLSE:GENETEC) Can Manage Its Debt Responsibly

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.' 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. We note that Genetec Technology Berhad (KLSE:GENETEC) 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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Genetec Technology Berhad

How Much Debt Does Genetec Technology Berhad Carry?

As you can see below, at the end of September 2020, Genetec Technology Berhad had RM22.5m of debt, up from RM17.0m a year ago. Click the image for more detail. On the flip side, it has RM20.4m in cash leading to net debt of about RM2.16m.

How Strong Is Genetec Technology Berhad's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Genetec Technology Berhad had liabilities of RM40.0m due within 12 months and liabilities of RM9.71m due beyond that. On the other hand, it had cash of RM20.4m and RM50.8m worth of receivables due within a year. So it actually has RM21.5m more liquid assets than total liabilities.

This excess liquidity suggests that Genetec Technology Berhad is taking a careful approach to debt. Because it has plenty of assets, it is unlikely to have trouble with its lenders.

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

Genetec Technology Berhad has net debt of just 0.24 times EBITDA, indicating that it is certainly not a reckless borrower. And this view is supported by the solid interest coverage, with EBIT coming in at 7.8 times the interest expense over the last year. Even more impressive was the fact that Genetec Technology Berhad grew its EBIT by 122% over twelve months. If maintained that growth will make the debt even more manageable in the years ahead. There's no doubt that we learn most about debt from the balance sheet. But it is Genetec Technology Berhad's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Genetec Technology Berhad created free cash flow amounting to 6.0% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

Happily, Genetec Technology Berhad's impressive EBIT growth rate 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. Looking at the bigger picture, we think Genetec Technology Berhad's use of debt seems quite reasonable and we're not concerned about it. After all, sensible leverage can boost returns on equity. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 4 warning signs for Genetec Technology Berhad you should be aware of, and 1 of them is a bit concerning.

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. 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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