Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that ‘Volatility is far from synonymous with risk’. So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Cherng Tay Technology Co., Ltd. (GTSM:4767) does use debt in its business. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
Generally speaking, debt only becomes a real problem when a company can’t easily pay it off, either by raising capital or with its own cash flow. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company’s use of debt, we first look at cash and debt together.
How Much Debt Does Cherng Tay Technology Carry?
As you can see below, at the end of September 2019, Cherng Tay Technology had NT$155.1m of debt, up from NT$190 a year ago. Click the image for more detail. However, it does have NT$400.3m in cash offsetting this, leading to net cash of NT$245.2m.
How Strong Is Cherng Tay Technology’s Balance Sheet?
According to the last reported balance sheet, Cherng Tay Technology had liabilities of NT$285.2m due within 12 months, and liabilities of NT$279.0m due beyond 12 months. On the other hand, it had cash of NT$400.3m and NT$301.5m worth of receivables due within a year. So it can boast NT$137.6m more liquid assets than total liabilities.
This excess liquidity suggests that Cherng Tay Technology is taking a careful approach to debt. Due to its strong net asset position, it is not likely to face issues with its lenders. Simply put, the fact that Cherng Tay Technology has more cash than debt is arguably a good indication that it can manage its debt safely.
But the bad news is that Cherng Tay Technology has seen its EBIT plunge 12% in the last twelve months. If that rate of decline in earnings continues, the company could find itself in a tight spot. There’s no doubt that we learn most about debt from the balance sheet. But you can’t view debt in total isolation; since Cherng Tay Technology will need earnings to service that debt. So when considering debt, it’s definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. While Cherng Tay 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. During the last three years, Cherng Tay Technology generated free cash flow amounting to a very robust 91% of its EBIT, more than we’d expect. That puts it in a very strong position to pay down debt.
While we empathize with investors who find debt concerning, you should keep in mind that Cherng Tay Technology has net cash of NT$245.2m, as well as more liquid assets than liabilities. And it impressed us with free cash flow of NT$6.9m, being 91% of its EBIT. So we don’t think Cherng Tay Technology’s use of debt is risky. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet – far from it. Case in point: We’ve spotted 4 warning signs for Cherng Tay Technology you should be aware of, and 1 of them can’t be ignored.
Of course, if you’re the type of investor who prefers buying stocks without the burden of debt, then don’t hesitate to discover our exclusive list of net cash growth stocks, today.
If you spot an error that warrants correction, please contact the editor at email@example.com. 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. Simply Wall St has no position in the stocks mentioned.
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