Action Electronics (TPE:3024) Has A Pretty Healthy Balance Sheet

Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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. As with many other companies Action Electronics Co., Ltd. (TPE:3024) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. 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 examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Action Electronics

How Much Debt Does Action Electronics Carry?

The image below, which you can click on for greater detail, shows that Action Electronics had debt of NT$555.9m at the end of September 2020, a reduction from NT$592.9m over a year. However, its balance sheet shows it holds NT$783.1m in cash, so it actually has NT$227.2m net cash.

How Healthy Is Action Electronics' Balance Sheet?

According to the last reported balance sheet, Action Electronics had liabilities of NT$891.1m due within 12 months, and liabilities of NT$228.1m due beyond 12 months. Offsetting this, it had NT$783.1m in cash and NT$252.0m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$84.1m.

Given Action Electronics has a market capitalization of NT$3.38b, it's hard to believe these liabilities pose much 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, Action Electronics boasts net cash, so it's fair to say it does not have a heavy debt load!

In fact Action Electronics's saving grace is its low debt levels, because its EBIT has tanked 47% in the last twelve months. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Action Electronics 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. Action Electronics 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. Happily for any shareholders, Action Electronics actually produced more free cash flow than EBIT over the last two years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Summing up

While it is always sensible to look at a company's total liabilities, it is very reassuring that Action Electronics has NT$227.2m in net cash. The cherry on top was that in converted 557% of that EBIT to free cash flow, bringing in NT$137m. So we don't have any problem with Action Electronics's use of debt. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. We've identified 1 warning sign with Action Electronics , and understanding them should be part of your investment process.

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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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. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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