ECOVE Environment (GTSM:6803) Could Easily Take On More Debt

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 note that ECOVE Environment Corp. (GTSM:6803) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt A Problem?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own 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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for ECOVE Environment

What Is ECOVE Environment's Net Debt?

The image below, which you can click on for greater detail, shows that at December 2020 ECOVE Environment had debt of NT$2.01b, up from NT$1.87b in one year. But it also has NT$2.18b in cash to offset that, meaning it has NT$169.2m net cash.

A Look At ECOVE Environment's Liabilities

The latest balance sheet data shows that ECOVE Environment had liabilities of NT$2.26b due within a year, and liabilities of NT$1.97b falling due after that. Offsetting this, it had NT$2.18b in cash and NT$1.38b in receivables that were due within 12 months. So it has liabilities totalling NT$673.8m more than its cash and near-term receivables, combined.

Given ECOVE Environment has a market capitalization of NT$15.4b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. While it does have liabilities worth noting, ECOVE Environment also has more cash than debt, so we're pretty confident it can manage its debt safely.

Fortunately, ECOVE Environment grew its EBIT by 3.3% in the last year, making that debt load look even more manageable. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine ECOVE Environment's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While ECOVE Environment has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. During the last three years, ECOVE Environment generated free cash flow amounting to a very robust 89% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Summing up

We could understand if investors are concerned about ECOVE Environment's liabilities, but we can be reassured by the fact it has has net cash of NT$169.2m. And it impressed us with free cash flow of NT$254m, being 89% of its EBIT. So is ECOVE Environment's debt a risk? It doesn't seem so to us. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 1 warning sign for ECOVE Environment that you should be aware of.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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