We Think Grand-Tek Technology (GTSM:3684) Can Stay On Top Of Its 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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Grand-Tek Technology Co., Ltd. (GTSM:3684) does carry debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Grand-Tek Technology

What Is Grand-Tek Technology's Debt?

You can click the graphic below for the historical numbers, but it shows that Grand-Tek Technology had NT$202.0m of debt in September 2020, down from NT$237.0m, one year before. However, it also had NT$193.9m in cash, and so its net debt is NT$8.08m.

A Look At Grand-Tek Technology's Liabilities

According to the last reported balance sheet, Grand-Tek Technology had liabilities of NT$135.7m due within 12 months, and liabilities of NT$201.7m due beyond 12 months. Offsetting this, it had NT$193.9m in cash and NT$134.4m in receivables that were due within 12 months. So its liabilities total NT$9.17m more than the combination of its cash and short-term receivables.

This state of affairs indicates that Grand-Tek Technology's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So it's very unlikely that the NT$899.7m company is short on cash, but still worth keeping an eye on the balance sheet. Carrying virtually no net debt, Grand-Tek Technology has a very light debt load indeed.

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).

With debt at a measly 0.085 times EBITDA and EBIT covering interest a whopping 62.4 times, it's clear that Grand-Tek Technology is not a desperate borrower. Indeed relative to its earnings its debt load seems light as a feather. Also positive, Grand-Tek Technology grew its EBIT by 25% in the last year, and that should make it easier to pay down debt, going forward. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Grand-Tek Technology will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Grand-Tek Technology 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

The good news is that Grand-Tek Technology's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But we must concede we find its conversion of EBIT to free cash flow has the opposite effect. All these things considered, it appears that Grand-Tek Technology can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 5 warning signs with Grand-Tek Technology (at least 2 which are concerning) , and understanding them should be part of your investment process.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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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