Sincere Security (GTSM:6721) Could Easily Take On More Debt

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.' 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. As with many other companies Sincere Security Co. Ltd. (GTSM:6721) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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, 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. 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 Sincere Security

What Is Sincere Security's Net Debt?

The image below, which you can click on for greater detail, shows that Sincere Security had debt of NT$52.3m at the end of June 2020, a reduction from NT$100.5m over a year. But it also has NT$203.9m in cash to offset that, meaning it has NT$151.6m net cash.

How Healthy Is Sincere Security's Balance Sheet?

The latest balance sheet data shows that Sincere Security had liabilities of NT$294.0m due within a year, and liabilities of NT$43.7m falling due after that. On the other hand, it had cash of NT$203.9m and NT$322.7m worth of receivables due within a year. So it actually has NT$188.9m more liquid assets than total liabilities.

This excess liquidity suggests that Sincere Security is taking a careful approach to debt. Given it has easily adequate short term liquidity, we don't think it will have any issues with its lenders. Simply put, the fact that Sincere Security has more cash than debt is arguably a good indication that it can manage its debt safely.

Better yet, Sincere Security grew its EBIT by 117% last year, which is an impressive improvement. If maintained that growth will make the debt even more manageable in the years ahead. When analysing debt levels, the balance sheet is the obvious place to start. But it is Sincere Security'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Sincere Security 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, Sincere Security recorded free cash flow worth 61% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Summing up

While it is always sensible to investigate a company's debt, in this case Sincere Security has NT$151.6m in net cash and a decent-looking balance sheet. And it impressed us with its EBIT growth of 117% over the last year. So we don't think Sincere Security's use of debt is risky. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 2 warning signs for Sincere Security that you should be aware of before investing here.

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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