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. We can see that Wonderful Hi-tech Co., Ltd. (GTSM:6190) does use debt in its business. But the more important question is: how much risk is that debt creating?
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. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company’s debt levels is to consider its cash and debt together.
What Is Wonderful Hi-tech’s Net Debt?
The chart below, which you can click on for greater detail, shows that Wonderful Hi-tech had NT$1.40b in debt in September 2019; about the same as the year before. However, because it has a cash reserve of NT$477.4m, its net debt is less, at about NT$926.4m.
How Healthy Is Wonderful Hi-tech’s Balance Sheet?
We can see from the most recent balance sheet that Wonderful Hi-tech had liabilities of NT$2.03b falling due within a year, and liabilities of NT$252.6m due beyond that. Offsetting this, it had NT$477.4m in cash and NT$1.17b in receivables that were due within 12 months. So its liabilities total NT$632.5m more than the combination of its cash and short-term receivables.
This deficit isn’t so bad because Wonderful Hi-tech is worth NT$2.28b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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.
Wonderful Hi-tech’s net debt of 2.1 times EBITDA suggests graceful use of debt. And the fact that its trailing twelve months of EBIT was 9.4 times its interest expenses harmonizes with that theme. Importantly, Wonderful Hi-tech grew its EBIT by 30% over the last twelve months, and that growth will make it easier to handle its debt. There’s no doubt that we learn most about debt from the balance sheet. 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, while the tax-man may adore accounting profits, lenders only accept 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, Wonderful Hi-tech reported free cash flow worth 19% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.
On our analysis Wonderful Hi-tech’s EBIT growth rate should signal that it won’t have too much trouble with its debt. But the other factors we noted above weren’t so encouraging. For instance it seems like it has to struggle a bit to convert EBIT to free cash flow. Considering this range of data points, we think Wonderful Hi-tech is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. 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. For instance, we’ve identified 4 warning signs for Wonderful Hi-tech (1 doesn’t sit too well with us) you should be aware of.
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.
If you spot an error that warrants correction, please contact the editor at email@example.com. 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. Simply Wall St has no position in the stocks mentioned.
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