Perfect Medical Industry (GTSM:6543) Could Easily Take On More Debt

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Perfect Medical Industry Co., Ltd. (GTSM:6543) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Perfect Medical Industry

How Much Debt Does Perfect Medical Industry Carry?

You can click the graphic below for the historical numbers, but it shows that as of June 2020 Perfect Medical Industry had NT$154.4m of debt, an increase on NT$76.4m, over one year. However, it also had NT$146.9m in cash, and so its net debt is NT$7.51m.

How Strong Is Perfect Medical Industry's Balance Sheet?

According to the last reported balance sheet, Perfect Medical Industry had liabilities of NT$276.7m due within 12 months, and liabilities of NT$36.4m due beyond 12 months. On the other hand, it had cash of NT$146.9m and NT$101.6m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$64.6m.

Given Perfect Medical Industry has a market capitalization of NT$967.7m, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. But either way, Perfect Medical Industry has virtually no net debt, so it's fair to say it does not have a heavy debt load!

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Perfect Medical Industry has very little debt (net of cash), and boasts a debt to EBITDA ratio of 0.074 and EBIT of 79.0 times the interest expense. Indeed relative to its earnings its debt load seems light as a feather. On top of that, Perfect Medical Industry grew its EBIT by 65% over the last twelve months, and that growth will make it easier to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Perfect Medical Industry's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Perfect Medical Industry's free cash flow amounted to 35% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

Happily, Perfect Medical Industry's impressive interest cover implies it has the upper hand on its debt. But, on a more sombre note, we are a little concerned by its conversion of EBIT to free cash flow. It's also worth noting that Perfect Medical Industry is in the Medical Equipment industry, which is often considered to be quite defensive. Looking at the bigger picture, we think Perfect Medical Industry's use of debt seems quite reasonable and we're not concerned about it. While debt does bring risk, when used wisely it can also bring a higher return on equity. 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. For instance, we've identified 3 warning signs for Perfect Medical Industry that you should be aware of.

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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