Here's Why Taihan Precision Technology (GTSM:1336) Can Manage Its Debt Responsibly

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Taihan Precision Technology Co., Ltd. (GTSM:1336) makes use of debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Taihan Precision Technology

How Much Debt Does Taihan Precision Technology Carry?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Taihan Precision Technology had NT$341.2m of debt, an increase on NT$239.5m, over one year. But it also has NT$602.9m in cash to offset that, meaning it has NT$261.7m net cash.

How Healthy Is Taihan Precision Technology's Balance Sheet?

The latest balance sheet data shows that Taihan Precision Technology had liabilities of NT$551.7m due within a year, and liabilities of NT$223.1m falling due after that. On the other hand, it had cash of NT$602.9m and NT$382.8m worth of receivables due within a year. So it can boast NT$210.9m more liquid assets than total liabilities.

This surplus suggests that Taihan Precision Technology has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that Taihan Precision Technology has more cash than debt is arguably a good indication that it can manage its debt safely.

The modesty of its debt load may become crucial for Taihan Precision Technology if management cannot prevent a repeat of the 35% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. There's no doubt that we learn most about debt from the balance sheet. But it is Taihan Precision Technology's earnings that will influence how the balance sheet holds up in the future. 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. While Taihan Precision Technology 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. Over the most recent three years, Taihan Precision Technology recorded free cash flow worth 72% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that Taihan Precision Technology has net cash of NT$261.7m, as well as more liquid assets than liabilities. The cherry on top was that in converted 72% of that EBIT to free cash flow, bringing in NT$96m. So we don't have any problem with Taihan Precision Technology's use of debt. 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 3 warning signs we've spotted with Taihan Precision Technology .

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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