Mobiletron ElectronicsLtd (TPE:1533) Takes On Some Risk With Its Use Of Debt

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.' 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. Importantly, Mobiletron Electronics Co.,Ltd. (TPE:1533) does carry debt. But the real question is whether this debt is making the company risky.

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. If things get really bad, the lenders can take control of the business. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.

View our latest analysis for Mobiletron ElectronicsLtd

What Is Mobiletron ElectronicsLtd's Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Mobiletron ElectronicsLtd had NT$2.26b of debt, an increase on NT$1.66b, over one year. However, because it has a cash reserve of NT$1.62b, its net debt is less, at about NT$635.9m.

How Healthy Is Mobiletron ElectronicsLtd's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Mobiletron ElectronicsLtd had liabilities of NT$1.82b due within 12 months and liabilities of NT$1.71b due beyond that. On the other hand, it had cash of NT$1.62b and NT$506.5m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$1.40b.

This deficit isn't so bad because Mobiletron ElectronicsLtd is worth NT$3.40b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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

Mobiletron ElectronicsLtd has a debt to EBITDA ratio of 4.1, which signals significant debt, but is still pretty reasonable for most types of business. But its EBIT was about 18.8 times its interest expense, implying the company isn't really paying a high cost to maintain that level of debt. Even were the low cost to prove unsustainable, that is a good sign. Shareholders should be aware that Mobiletron ElectronicsLtd's EBIT was down 85% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. When analysing debt levels, the balance sheet is the obvious place to start. But it is Mobiletron ElectronicsLtd'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Mobiletron ElectronicsLtd burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both Mobiletron ElectronicsLtd's conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Looking at the bigger picture, it seems clear to us that Mobiletron ElectronicsLtd's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. 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 Mobiletron ElectronicsLtd is showing 2 warning signs in our investment analysis , and 1 of those is potentially serious...

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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