We Think Highlight Tech (GTSM:6208) Is Taking Some Risk With Its 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.' 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 Highlight Tech Corp. (GTSM:6208) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Highlight Tech

What Is Highlight Tech's Debt?

The image below, which you can click on for greater detail, shows that at September 2020 Highlight Tech had debt of NT$1.24b, up from NT$332.7m in one year. On the flip side, it has NT$485.6m in cash leading to net debt of about NT$751.5m.

A Look At Highlight Tech's Liabilities

Zooming in on the latest balance sheet data, we can see that Highlight Tech had liabilities of NT$1.45b due within 12 months and liabilities of NT$843.7m due beyond that. Offsetting these obligations, it had cash of NT$485.6m as well as receivables valued at NT$510.0m due within 12 months. So it has liabilities totalling NT$1.30b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Highlight Tech has a market capitalization of NT$3.87b, and so it could probably strengthen its balance sheet by raising capital if it needed to. 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Highlight Tech's net debt to EBITDA ratio of about 2.1 suggests only moderate use of debt. And its strong interest cover of 68.6 times, makes us even more comfortable. Unfortunately, Highlight Tech saw its EBIT slide 7.8% in the last twelve months. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. When analysing debt levels, the balance sheet is the obvious place to start. But it is Highlight Tech'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.

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, Highlight Tech burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Neither Highlight Tech's ability to convert EBIT to free cash flow nor its EBIT growth rate gave us confidence in its ability to take on more debt. But its interest cover tells a very different story, and suggests some resilience. Taking the abovementioned factors together we do think Highlight Tech's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. Like risks, for instance. Every company has them, and we've spotted 4 warning signs for Highlight Tech (of which 1 is significant!) 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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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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