Here's Why Taiwan Optical Platform (TPE:6464) Can Manage Its Debt Responsibly

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 can see that Taiwan Optical Platform Co., Ltd. (TPE:6464) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Taiwan Optical Platform

What Is Taiwan Optical Platform's Debt?

The image below, which you can click on for greater detail, shows that at September 2020 Taiwan Optical Platform had debt of NT$10.8b, up from NT$710.0m in one year. However, it does have NT$2.18b in cash offsetting this, leading to net debt of about NT$8.63b.

How Strong Is Taiwan Optical Platform's Balance Sheet?

According to the last reported balance sheet, Taiwan Optical Platform had liabilities of NT$2.23b due within 12 months, and liabilities of NT$11.1b due beyond 12 months. Offsetting this, it had NT$2.18b in cash and NT$339.1m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$10.8b.

This deficit is considerable relative to its market capitalization of NT$13.8b, so it does suggest shareholders should keep an eye on Taiwan Optical Platform's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Taiwan Optical Platform has net debt to EBITDA of 4.4 suggesting it uses a fair bit of leverage to boost returns. On the plus side, its EBIT was 8.8 times its interest expense, and its net debt to EBITDA, was quite high, at 4.4. It is well worth noting that Taiwan Optical Platform's EBIT shot up like bamboo after rain, gaining 80% in the last twelve months. That'll make it easier to manage its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Taiwan Optical Platform'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 it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Taiwan Optical Platform recorded free cash flow worth a fulsome 95% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Our View

Happily, Taiwan Optical Platform's impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. But the stark truth is that we are concerned by its net debt to EBITDA. All these things considered, it appears that Taiwan Optical Platform can comfortably handle its current debt levels. 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. 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. Be aware that Taiwan Optical Platform is showing 3 warning signs in our investment analysis , and 1 of those makes us a bit uncomfortable...

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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