Is Eslite Spectrum (GTSM:2926) Using Too Much 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.' 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. Importantly, The Eslite Spectrum Corporation (GTSM:2926) does carry debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Eslite Spectrum

What Is Eslite Spectrum's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Eslite Spectrum had NT$253.0m of debt, an increase on none, over one year. However, its balance sheet shows it holds NT$884.2m in cash, so it actually has NT$631.2m net cash.

How Healthy Is Eslite Spectrum's Balance Sheet?

The latest balance sheet data shows that Eslite Spectrum had liabilities of NT$3.65b due within a year, and liabilities of NT$8.65b falling due after that. Offsetting these obligations, it had cash of NT$884.2m as well as receivables valued at NT$802.0m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$10.6b.

The deficiency here weighs heavily on the NT$3.80b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. At the end of the day, Eslite Spectrum would probably need a major re-capitalization if its creditors were to demand repayment. Eslite Spectrum boasts net cash, so it's fair to say it does not have a heavy debt load, even if it does have very significant liabilities, in total.

Importantly, Eslite Spectrum's EBIT fell a jaw-dropping 37% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. 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 Eslite Spectrum 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 company can only pay off debt with cold hard cash, not accounting profits. While Eslite Spectrum 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 last three years, Eslite Spectrum actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Summing up

Although Eslite Spectrum's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of NT$631.2m. And it impressed us with free cash flow of NT$883m, being 284% of its EBIT. Despite the cash, we do find Eslite Spectrum's level of total liabilities concerning, so we're not particularly comfortable with the stock. 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. Consider for instance, the ever-present spectre of investment risk. We've identified 3 warning signs with Eslite Spectrum (at least 1 which doesn't sit too well with us) , and understanding them should be part of your investment process.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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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