These 4 Measures Indicate That ADATA Technology (GTSM:3260) Is Using Debt Reasonably Well

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that ADATA Technology Co., Ltd. (GTSM:3260) does use debt in its business. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. 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 step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for ADATA Technology

How Much Debt Does ADATA Technology Carry?

As you can see below, ADATA Technology had NT$12.6b of debt at September 2020, down from NT$14.8b a year prior. However, because it has a cash reserve of NT$2.81b, its net debt is less, at about NT$9.82b.

A Look At ADATA Technology's Liabilities

We can see from the most recent balance sheet that ADATA Technology had liabilities of NT$10.3b falling due within a year, and liabilities of NT$7.59b due beyond that. On the other hand, it had cash of NT$2.81b and NT$4.48b worth of receivables due within a year. So it has liabilities totalling NT$10.6b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of NT$14.8b, so it does suggest shareholders should keep an eye on ADATA Technology'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 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.

Strangely ADATA Technology has a sky high EBITDA ratio of 5.4, implying high debt, but a strong interest coverage of 10.2. So either it has access to very cheap long term debt or that interest expense is going to grow! Notably, ADATA Technology made a loss at the EBIT level, last year, but improved that to positive EBIT of NT$1.6b in the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if ADATA Technology can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, ADATA Technology actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

On our analysis ADATA Technology's conversion of EBIT to free cash flow should signal that it won't have too much trouble with its debt. But the other factors we noted above weren't so encouraging. To be specific, it seems about as good at managing its debt, based on its EBITDA, as wet socks are at keeping your feet warm. When we consider all the factors mentioned above, we do feel a bit cautious about ADATA Technology's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Take risks, for example - ADATA Technology has 1 warning sign we think you should be aware of.

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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