These 4 Measures Indicate That Pancolour Ink (GTSM:4765) Is Using Debt Reasonably Well

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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 Pancolour Ink Co., Ltd. (GTSM:4765) makes use of debt. But the more important question is: how much risk is that debt creating?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Pancolour Ink

What Is Pancolour Ink's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Pancolour Ink had NT$284.6m of debt in June 2020, down from NT$352.0m, one year before. However, it also had NT$92.6m in cash, and so its net debt is NT$192.0m.

A Look At Pancolour Ink's Liabilities

According to the last reported balance sheet, Pancolour Ink had liabilities of NT$237.1m due within 12 months, and liabilities of NT$180.9m due beyond 12 months. Offsetting these obligations, it had cash of NT$92.6m as well as receivables valued at NT$110.1m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$215.4m.

This deficit isn't so bad because Pancolour Ink is worth NT$859.6m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Pancolour Ink's net debt is only 1.3 times its EBITDA. And its EBIT easily covers its interest expense, being 37.4 times the size. So we're pretty relaxed about its super-conservative use of debt. And we also note warmly that Pancolour Ink grew its EBIT by 16% last year, making its debt load easier to handle. There's no doubt that we learn most about debt from the balance sheet. But it is Pancolour Ink'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 we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Pancolour Ink recorded free cash flow of 40% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

The good news is that Pancolour Ink's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And the good news does not stop there, as its EBIT growth rate also supports that impression! Looking at all the aforementioned factors together, it strikes us that Pancolour Ink can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. 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. Take risks, for example - Pancolour Ink has 3 warning signs we think 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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