Koan Hao Technology (GTSM:8354) Takes On Some Risk With Its Use Of Debt

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Koan Hao Technology Co., Ltd. (GTSM:8354) does use debt in its business. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, 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.

View our latest analysis for Koan Hao Technology

What Is Koan Hao Technology's Net Debt?

As you can see below, at the end of September 2020, Koan Hao Technology had NT$1.41b of debt, up from NT$1.28b a year ago. Click the image for more detail. However, because it has a cash reserve of NT$701.2m, its net debt is less, at about NT$707.0m.

How Healthy Is Koan Hao Technology's Balance Sheet?

We can see from the most recent balance sheet that Koan Hao Technology had liabilities of NT$1.05b falling due within a year, and liabilities of NT$684.2m due beyond that. On the other hand, it had cash of NT$701.2m and NT$227.4m worth of receivables due within a year. So it has liabilities totalling NT$808.4m more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of NT$1.29b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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).

Strangely Koan Hao Technology has a sky high EBITDA ratio of 5.9, implying high debt, but a strong interest coverage of 1k. So either it has access to very cheap long term debt or that interest expense is going to grow! Notably, Koan Hao Technology's EBIT launched higher than Elon Musk, gaining a whopping 5,883% on last year. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Koan Hao Technology will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

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, Koan Hao Technology 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

We feel some trepidation about Koan Hao Technology's difficulty conversion of EBIT to free cash flow, but we've got positives to focus on, too. For example, its interest cover and EBIT growth rate give us some confidence in its ability to manage its debt. Looking at all the angles mentioned above, it does seem to us that Koan Hao Technology is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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 learn about the 4 warning signs we've spotted with Koan Hao Technology (including 1 which is a bit unpleasant) .

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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