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 seems the smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess how risky a company is. We can see that TECO Electric & Machinery Co., Ltd. (TPE:1504) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
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. If things get really bad, the lenders can take control of the business. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company’s use of debt, we first look at cash and debt together.
What Is TECO Electric & Machinery’s Debt?
You can click the graphic below for the historical numbers, but it shows that TECO Electric & Machinery had NT$13.3b of debt in September 2019, down from NT$15.3b, one year before. But it also has NT$19.9b in cash to offset that, meaning it has NT$6.59b net cash.
A Look At TECO Electric & Machinery’s Liabilities
The latest balance sheet data shows that TECO Electric & Machinery had liabilities of NT$20.7b due within a year, and liabilities of NT$16.8b falling due after that. Offsetting these obligations, it had cash of NT$19.9b as well as receivables valued at NT$12.3b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$5.31b.
Since publicly traded TECO Electric & Machinery shares are worth a total of NT$52.1b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it’s clear that we should continue to monitor its balance sheet, lest it change for the worse. Despite its noteworthy liabilities, TECO Electric & Machinery boasts net cash, so it’s fair to say it does not have a heavy debt load!
The good news is that TECO Electric & Machinery has increased its EBIT by 6.3% over twelve months, which should ease any concerns about debt repayment. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if TECO Electric & Machinery can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. TECO Electric & Machinery may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last three years, TECO Electric & Machinery generated free cash flow amounting to a very robust 98% of its EBIT, more than we’d expect. That positions it well to pay down debt if desirable to do so.
While TECO Electric & Machinery does have more liabilities than liquid assets, it also has net cash of NT$6.59b. The cherry on top was that in converted 98% of that EBIT to free cash flow, bringing in NT$4.8b. So is TECO Electric & Machinery’s debt a risk? It doesn’t seem so to us. 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. Consider for instance, the ever-present spectre of investment risk. We’ve identified 1 warning sign with TECO Electric & Machinery , and understanding them should be part of your investment process.
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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