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. We note that TCI Co., Ltd. (GTSM:8436) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does TCI Carry?
As you can see below, at the end of September 2020, TCI had NT$1.51b of debt, up from NT$930.7m a year ago. Click the image for more detail. However, it does have NT$4.70b in cash offsetting this, leading to net cash of NT$3.19b.
A Look At TCI's Liabilities
We can see from the most recent balance sheet that TCI had liabilities of NT$4.32b falling due within a year, and liabilities of NT$78.7m due beyond that. Offsetting these obligations, it had cash of NT$4.70b as well as receivables valued at NT$775.9m due within 12 months. So it actually has NT$1.08b more liquid assets than total liabilities.
This short term liquidity is a sign that TCI could probably pay off its debt with ease, as its balance sheet is far from stretched. Succinctly put, TCI boasts net cash, so it's fair to say it does not have a heavy debt load!
The modesty of its debt load may become crucial for TCI if management cannot prevent a repeat of the 22% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if TCI 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. TCI 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. During the last three years, TCI produced sturdy free cash flow equating to 62% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
While we empathize with investors who find debt concerning, you should keep in mind that TCI has net cash of NT$3.19b, as well as more liquid assets than liabilities. So we don't have any problem with TCI's use of debt. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Consider for instance, the ever-present spectre of investment risk. We've identified 2 warning signs with TCI , 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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TCI Co., Ltd., an original design manufacturer company, engages in the research, development, manufactures, and sales of functional health food, food supplements, and skin care products.
Excellent balance sheet with reasonable growth potential.
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