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. We note that Asia Metal Industries, Inc. (GTSM:6727) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
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. 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. 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.
How Much Debt Does Asia Metal Industries Carry?
The image below, which you can click on for greater detail, shows that at September 2020 Asia Metal Industries had debt of NT$294.8m, up from NT$42.2m in one year. On the flip side, it has NT$290.2m in cash leading to net debt of about NT$4.67m.
A Look At Asia Metal Industries' Liabilities
Zooming in on the latest balance sheet data, we can see that Asia Metal Industries had liabilities of NT$1.27b due within 12 months and liabilities of NT$13.1m due beyond that. Offsetting this, it had NT$290.2m in cash and NT$255.1m in receivables that were due within 12 months. So it has liabilities totalling NT$741.8m more than its cash and near-term receivables, combined.
This is a mountain of leverage relative to its market capitalization of NT$1.05b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution. Carrying virtually no net debt, Asia Metal Industries has a very light debt load indeed.
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). 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).
Asia Metal Industries has barely any net debt, as demonstrated by its net debt to EBITDA ratio of only 0.033. Happily, it actually managed to receive more interest than it paid, over the last year. So there's no doubt this company can take on debt as easily as enthusiastic spray-tanners take on an orange hue. Fortunately, Asia Metal Industries grew its EBIT by 9.2% in the last year, making that debt load look even more manageable. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Asia Metal Industries can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Asia Metal Industries recorded free cash flow worth a fulsome 98% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.
Happily, Asia Metal Industries's impressive interest cover implies it has the upper hand on its debt. But truth be told we feel its level of total liabilities does undermine this impression a bit. When we consider the range of factors above, it looks like Asia Metal Industries is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example - Asia Metal Industries has 6 warning signs we think you should be aware of.
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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