Is Hu Lane Associate (GTSM:6279) A Risky Investment?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Hu Lane Associate Inc. (GTSM:6279) does use debt in its business. But the more important question is: how much risk is that debt creating?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Hu Lane Associate

What Is Hu Lane Associate's Net Debt?

As you can see below, Hu Lane Associate had NT$1.24b of debt at September 2020, down from NT$1.36b a year prior. However, because it has a cash reserve of NT$779.1m, its net debt is less, at about NT$455.9m.

A Look At Hu Lane Associate's Liabilities

We can see from the most recent balance sheet that Hu Lane Associate had liabilities of NT$1.98b falling due within a year, and liabilities of NT$191.0m due beyond that. Offsetting this, it had NT$779.1m in cash and NT$1.47b in receivables that were due within 12 months. So it actually has NT$77.9m more liquid assets than total liabilities.

Having regard to Hu Lane Associate's size, it seems that its liquid assets are well balanced with its total liabilities. So while it's hard to imagine that the NT$11.6b company is struggling for cash, we still think it's worth monitoring its balance sheet.

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).

Hu Lane Associate's net debt is only 0.52 times its EBITDA. And its EBIT easily covers its interest expense, being 56.7 times the size. So we're pretty relaxed about its super-conservative use of debt. Another good sign is that Hu Lane Associate has been able to increase its EBIT by 25% in twelve months, making it easier to pay down debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Hu Lane Associate 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Hu Lane Associate produced sturdy free cash flow equating to 61% 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

Hu Lane Associate's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And that's just the beginning of the good news since its EBIT growth rate is also very heartening. Overall, we don't think Hu Lane Associate is taking any bad risks, as its debt load seems modest. So we're not worried about the use of a little leverage on 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. Be aware that Hu Lane Associate is showing 2 warning signs 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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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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