Is Action Electronics (TPE:3024) A Risky Investment?

Warren Buffett famously said, '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. Importantly, Action Electronics Co., Ltd. (TPE:3024) does carry debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out 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. But on the other hand it also has NT$783.1m in cash, leading to a NT$227.2m net cash position.

A Look At Action Electronics's Liabilities

Zooming in on the latest balance sheet data, we can see that Action Electronics had liabilities of NT$891.1m due within 12 months and liabilities of NT$228.1m due beyond that. Offsetting these obligations, it had cash of NT$783.1m as well as receivables valued at NT$252.0m due within 12 months. So its liabilities total NT$84.1m more than the combination of its cash and short-term receivables.

Given Action Electronics has a market capitalization of NT$3.22b, 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, Action Electronics also has more cash than debt, so we're pretty confident it can manage its debt safely.

It is just as well that Action Electronics's load is not too heavy, because its EBIT was down 47% over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. There's no doubt that we learn most about debt from the balance sheet. 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. 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. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

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. And it impressed us with free cash flow of NT$137m, being 557% of its EBIT. So we don't have any problem with Action Electronics's use of debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 1 warning sign for Action Electronics you should be aware of.

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.

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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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