Gourmet Master (TPE:2723) Seems To Use Debt Quite Sensibly

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 Gourmet Master Co. Ltd. (TPE:2723) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Gourmet Master

How Much Debt Does Gourmet Master Carry?

As you can see below, at the end of September 2020, Gourmet Master had NT$1.14b of debt, up from NT$566.3m a year ago. Click the image for more detail. However, its balance sheet shows it holds NT$5.97b in cash, so it actually has NT$4.83b net cash.

How Healthy Is Gourmet Master's Balance Sheet?

We can see from the most recent balance sheet that Gourmet Master had liabilities of NT$7.38b falling due within a year, and liabilities of NT$4.70b due beyond that. Offsetting these obligations, it had cash of NT$5.97b as well as receivables valued at NT$673.9m due within 12 months. So its liabilities total NT$5.44b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Gourmet Master has a market capitalization of NT$24.7b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. While it does have liabilities worth noting, Gourmet Master also has more cash than debt, so we're pretty confident it can manage its debt safely.

On the other hand, Gourmet Master's EBIT dived 14%, over the last year. If that rate of decline in earnings continues, the company could find itself in a tight spot. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Gourmet Master can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Gourmet Master 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. Happily for any shareholders, Gourmet Master actually produced more free cash flow than EBIT over the last three 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 Gourmet Master does have more liabilities than liquid assets, it also has net cash of NT$4.83b. And it impressed us with free cash flow of NT$2.3b, being 119% of its EBIT. So we are not troubled with Gourmet Master's debt use. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should be aware of the 2 warning signs we've spotted with Gourmet Master .

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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