Is Key Ware Electronics (GTSM:5498) Using Too Much Debt?

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.' 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. As with many other companies Key Ware Electronics Co., Ltd. (GTSM:5498) makes use of debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Key Ware Electronics

What Is Key Ware Electronics's Net Debt?

The image below, which you can click on for greater detail, shows that at December 2020 Key Ware Electronics had debt of NT$1.06b, up from NT$952.3m in one year. On the flip side, it has NT$854.3m in cash leading to net debt of about NT$202.6m.

A Look At Key Ware Electronics' Liabilities

Zooming in on the latest balance sheet data, we can see that Key Ware Electronics had liabilities of NT$992.0m due within 12 months and liabilities of NT$513.2m due beyond that. Offsetting these obligations, it had cash of NT$854.3m as well as receivables valued at NT$727.6m due within 12 months. So it actually has NT$76.6m more liquid assets than total liabilities.

This surplus suggests that Key Ware Electronics has a conservative balance sheet, and could probably eliminate its debt without much difficulty.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Given net debt is only 1.3 times EBITDA, it is initially surprising to see that Key Ware Electronics's EBIT has low interest coverage of 2.2 times. So while we're not necessarily alarmed we think that its debt is far from trivial. Importantly, Key Ware Electronics's EBIT fell a jaw-dropping 28% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. There's no doubt that we learn most about debt from the balance sheet. But it is Key Ware Electronics's earnings that will influence how the balance sheet holds up in the future. 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.

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. Over the last three years, Key Ware Electronics saw substantial negative free cash flow, in total. 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

To be frank both Key Ware Electronics'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 level of total liabilities is a good sign, and makes us more optimistic. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Key Ware Electronics stock a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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. For example, we've discovered 1 warning sign for Key Ware Electronics that you should be aware of before investing here.

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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