Klingon Aerospace (TPE:1529) Seems To Use Debt Quite Sensibly

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. As with many other companies Klingon Aerospace Inc. (TPE:1529) makes use of debt. But the real question is whether this debt is making the company risky.

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Klingon Aerospace

What Is Klingon Aerospace's Debt?

The image below, which you can click on for greater detail, shows that at September 2020 Klingon Aerospace had debt of NT$377.7m, up from NT$274.8m in one year. However, it does have NT$279.7m in cash offsetting this, leading to net debt of about NT$98.0m.

How Strong Is Klingon Aerospace's Balance Sheet?

According to the last reported balance sheet, Klingon Aerospace had liabilities of NT$222.4m due within 12 months, and liabilities of NT$316.7m due beyond 12 months. On the other hand, it had cash of NT$279.7m and NT$283.8m worth of receivables due within a year. So it actually has NT$24.5m more liquid assets than total liabilities.

This state of affairs indicates that Klingon Aerospace's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So it's very unlikely that the NT$1.52b company is short on cash, but still worth keeping an eye on the balance sheet.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its 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).

Klingon Aerospace's net debt is only 0.72 times its EBITDA. And its EBIT covers its interest expense a whopping 10.3 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Even more impressive was the fact that Klingon Aerospace grew its EBIT by 263% over twelve months. If maintained that growth will make the debt even more manageable in the years ahead. When analysing debt levels, the balance sheet is the obvious place to start. But it is Klingon Aerospace's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Klingon Aerospace burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

The good news is that Klingon Aerospace's demonstrated ability to grow its EBIT delights us like a fluffy puppy does a toddler. But the stark truth is that we are concerned by its conversion of EBIT to free cash flow. All these things considered, it appears that Klingon Aerospace can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. 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. To that end, you should be aware of the 2 warning signs we've spotted with Klingon Aerospace .

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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