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. As with many other companies Ardentec Corporation (GTSM:3264) makes use of debt. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
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. 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 step when considering a company's debt levels is to consider its cash and debt together.
See our latest analysis for Ardentec
What Is Ardentec's Debt?
As you can see below, at the end of December 2020, Ardentec had NT$6.18b of debt, up from NT$4.57b a year ago. Click the image for more detail. On the flip side, it has NT$3.34b in cash leading to net debt of about NT$2.84b.
How Strong Is Ardentec's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Ardentec had liabilities of NT$3.79b due within 12 months and liabilities of NT$6.15b due beyond that. On the other hand, it had cash of NT$3.34b and NT$2.58b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$4.01b.
Since publicly traded Ardentec shares are worth a total of NT$21.0b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.
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.
Ardentec's net debt is only 0.60 times its EBITDA. And its EBIT covers its interest expense a whopping 29.3 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On top of that, Ardentec grew its EBIT by 41% over the last twelve months, and that growth will make it easier to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But it is Ardentec's earnings that will influence how the balance sheet holds up in the future. 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. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Ardentec reported free cash flow worth 2.3% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.
Our View
Happily, Ardentec's impressive interest cover implies it has the upper hand on its debt. But we must concede we find its conversion of EBIT to free cash flow has the opposite effect. All these things considered, it appears that Ardentec can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. 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. We've identified 2 warning signs with Ardentec , and understanding them should be part of your investment process.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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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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About TPEX:3264
Ardentec
Provides semiconductor testing solutions in memory, logic, and mixed-signal ICs to integrated device manufacturers, pure play wafer foundry companies, and fabless design companies in the United States, Taiwan, Singapore, South Korea, China, Europe, and internationally.
Established dividend payer with adequate balance sheet.
