Here's Why Formosa Optical TechnologyLtd (GTSM:5312) Has A Meaningful Debt Burden

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, Formosa Optical Technology Co.,Ltd. (GTSM:5312) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Formosa Optical TechnologyLtd

How Much Debt Does Formosa Optical TechnologyLtd Carry?

As you can see below, at the end of September 2020, Formosa Optical TechnologyLtd had NT$916.6m of debt, up from NT$616.7m a year ago. Click the image for more detail. However, it also had NT$405.5m in cash, and so its net debt is NT$511.0m.

A Look At Formosa Optical TechnologyLtd's Liabilities

We can see from the most recent balance sheet that Formosa Optical TechnologyLtd had liabilities of NT$1.62b falling due within a year, and liabilities of NT$1.58b due beyond that. Offsetting these obligations, it had cash of NT$405.5m as well as receivables valued at NT$55.2m due within 12 months. So it has liabilities totalling NT$2.74b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of NT$3.50b, so it does suggest shareholders should keep an eye on Formosa Optical TechnologyLtd's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

We'd say that Formosa Optical TechnologyLtd's moderate net debt to EBITDA ratio ( being 2.0), indicates prudence when it comes to debt. And its strong interest cover of 14.3 times, makes us even more comfortable. Shareholders should be aware that Formosa Optical TechnologyLtd's EBIT was down 25% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. 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 Formosa Optical TechnologyLtd 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Formosa Optical TechnologyLtd 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.

Our View

While Formosa Optical TechnologyLtd's EBIT growth rate has us nervous. For example, its interest cover and conversion of EBIT to free cash flow give us some confidence in its ability to manage its debt. We think that Formosa Optical TechnologyLtd's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. 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. To that end, you should be aware of the 1 warning sign we've spotted with Formosa Optical TechnologyLtd .

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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