We Think Headway Advanced Materials (TPE:1776) Can Stay On Top Of Its 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.' 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 Headway Advanced Materials Inc. (TPE:1776) does use debt in its business. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Headway Advanced Materials

How Much Debt Does Headway Advanced Materials Carry?

The image below, which you can click on for greater detail, shows that at September 2020 Headway Advanced Materials had debt of NT$459.2m, up from NT$420.2m in one year. On the flip side, it has NT$353.8m in cash leading to net debt of about NT$105.5m.

A Look At Headway Advanced Materials' Liabilities

Zooming in on the latest balance sheet data, we can see that Headway Advanced Materials had liabilities of NT$512.3m due within 12 months and liabilities of NT$257.7m due beyond that. Offsetting this, it had NT$353.8m in cash and NT$335.8m in receivables that were due within 12 months. So its liabilities total NT$80.5m more than the combination of its cash and short-term receivables.

Since publicly traded Headway Advanced Materials shares are worth a total of NT$1.18b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Headway Advanced Materials's net debt is only 0.86 times its EBITDA. And its EBIT easily covers its interest expense, being 189 times the size. So we're pretty relaxed about its super-conservative use of debt. On top of that, Headway Advanced Materials grew its EBIT by 31% 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 you can't view debt in total isolation; since Headway Advanced Materials will need earnings to service that debt. 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 company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Headway Advanced Materials's free cash flow amounted to 21% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

The good news is that Headway Advanced Materials's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But, on a more sombre note, we are a little concerned by its conversion of EBIT to free cash flow. Taking all this data into account, it seems to us that Headway Advanced Materials takes a pretty sensible approach to debt. While that brings some risk, it can also enhance returns for shareholders. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Take risks, for example - Headway Advanced Materials has 3 warning signs (and 1 which can't be ignored) we think you should know about.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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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