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 can see that Actron Technology Corporation (GTSM:8255) does use debt in its business. But the more important question is: how much risk is that debt creating?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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.
How Much Debt Does Actron Technology Carry?
The chart below, which you can click on for greater detail, shows that Actron Technology had NT$1.59b in debt in September 2020; about the same as the year before. However, it does have NT$1.57b in cash offsetting this, leading to net debt of about NT$19.2m.
A Look At Actron Technology's Liabilities
The latest balance sheet data shows that Actron Technology had liabilities of NT$1.42b due within a year, and liabilities of NT$660.6m falling due after that. Offsetting this, it had NT$1.57b in cash and NT$494.1m in receivables that were due within 12 months. So its total liabilities are just about perfectly matched by its shorter-term, liquid assets.
Having regard to Actron Technology's size, it seems that its liquid assets are well balanced with its total liabilities. So it's very unlikely that the NT$10.9b company is short on cash, but still worth keeping an eye on the balance sheet. Carrying virtually no net debt, Actron Technology has a very light debt load indeed.
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).
With debt at a measly 0.04 times EBITDA and EBIT covering interest a whopping 15.1 times, it's clear that Actron Technology is not a desperate borrower. Indeed relative to its earnings its debt load seems light as a feather. The modesty of its debt load may become crucial for Actron Technology if management cannot prevent a repeat of the 49% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. When analysing debt levels, the balance sheet is the obvious place to start. But it is Actron Technology'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, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Actron Technology reported free cash flow worth 11% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.
Based on what we've seen Actron Technology is not finding it easy, given its EBIT growth rate, but the other factors we considered give us cause to be optimistic. In particular, we are dazzled with its interest cover. When we consider all the factors mentioned above, we do feel a bit cautious about Actron Technology's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Take risks, for example - Actron Technology has 3 warning signs (and 1 which shouldn't be ignored) we think you should know about.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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