Here's Why China Fineblanking TechnologyLtd (GTSM:1586) Can Manage Its Debt Responsibly

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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that China Fineblanking Technology Co.,Ltd. (GTSM:1586) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. If things get really bad, the lenders can take control of the business. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for China Fineblanking TechnologyLtd

How Much Debt Does China Fineblanking TechnologyLtd Carry?

The image below, which you can click on for greater detail, shows that at December 2020 China Fineblanking TechnologyLtd had debt of NT$1.69b, up from NT$1.56b in one year. However, because it has a cash reserve of NT$468.5m, its net debt is less, at about NT$1.22b.

How Strong Is China Fineblanking TechnologyLtd's Balance Sheet?

We can see from the most recent balance sheet that China Fineblanking TechnologyLtd had liabilities of NT$1.24b falling due within a year, and liabilities of NT$1.28b due beyond that. On the other hand, it had cash of NT$468.5m and NT$865.8m worth of receivables due within a year. So its liabilities total NT$1.18b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since China Fineblanking TechnologyLtd has a market capitalization of NT$3.94b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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). 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).

China Fineblanking TechnologyLtd has net debt to EBITDA of 3.0 suggesting it uses a fair bit of leverage to boost returns. On the plus side, its EBIT was 9.2 times its interest expense, and its net debt to EBITDA, was quite high, at 3.0. Pleasingly, China Fineblanking TechnologyLtd is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 279% gain in the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine China Fineblanking TechnologyLtd's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, China Fineblanking TechnologyLtd burned a lot of cash. 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

China Fineblanking TechnologyLtd's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered were considerably better. In particular, we are dazzled with its EBIT growth rate. Looking at all this data makes us feel a little cautious about China Fineblanking TechnologyLtd's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for China Fineblanking TechnologyLtd you should know about.

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.

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