Is Wonderful Hi-tech (GTSM:6190) Using Too Much Debt?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Wonderful Hi-tech Co., Ltd. (GTSM:6190) makes use of debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Wonderful Hi-tech

What Is Wonderful Hi-tech's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Wonderful Hi-tech had NT$1.49b of debt, an increase on NT$1.40b, over one year. However, it does have NT$332.2m in cash offsetting this, leading to net debt of about NT$1.16b.

A Look At Wonderful Hi-tech's Liabilities

The latest balance sheet data shows that Wonderful Hi-tech had liabilities of NT$2.16b due within a year, and liabilities of NT$250.0m falling due after that. Offsetting these obligations, it had cash of NT$332.2m as well as receivables valued at NT$1.25b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$819.8m.

Wonderful Hi-tech has a market capitalization of NT$2.33b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (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).

Wonderful Hi-tech's debt is 3.8 times its EBITDA, and its EBIT cover its interest expense 7.0 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Shareholders should be aware that Wonderful Hi-tech's EBIT was down 38% 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 you can't view debt in total isolation; since Wonderful Hi-tech will need earnings to service that debt. 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, Wonderful Hi-tech recorded free cash flow worth a fulsome 90% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Our View

Neither Wonderful Hi-tech's ability to grow its EBIT nor its net debt to EBITDA gave us confidence in its ability to take on more debt. But the good news is it seems to be able to convert EBIT to free cash flow with ease. Looking at all the angles mentioned above, it does seem to us that Wonderful Hi-tech is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. 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. For example, we've discovered 4 warning signs for Wonderful Hi-tech (1 is a bit unpleasant!) that you should be aware of before investing here.

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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