Higher Way Electronic (GTSM:3268) Seems To Use Debt Quite Sensibly

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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, Higher Way Electronic Co., Ltd. (GTSM:3268) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Higher Way Electronic

How Much Debt Does Higher Way Electronic Carry?

The image below, which you can click on for greater detail, shows that at September 2020 Higher Way Electronic had debt of NT$319.3m, up from NT$284.1m in one year. On the flip side, it has NT$121.8m in cash leading to net debt of about NT$197.5m.

How Strong Is Higher Way Electronic's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Higher Way Electronic had liabilities of NT$595.9m due within 12 months and liabilities of NT$56.3m due beyond that. Offsetting this, it had NT$121.8m in cash and NT$460.0m in receivables that were due within 12 months. So it has liabilities totalling NT$70.4m more than its cash and near-term receivables, combined.

Since publicly traded Higher Way Electronic shares are worth a total of NT$538.2m, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Higher Way Electronic has a rather high debt to EBITDA ratio of 16.3 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 4.4 times, suggesting it can responsibly service its obligations. However, the silver lining was that Higher Way Electronic achieved a positive EBIT of NT$9.9m in the last twelve months, an improvement on the prior year's loss. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Higher Way Electronic 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. 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, Higher Way Electronic 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

Based on what we've seen Higher Way Electronic is not finding it easy, given its net debt to EBITDA, but the other factors we considered give us cause to be optimistic. In particular, we are dazzled with its conversion of EBIT to free cash flow. Considering this range of data points, we think Higher Way Electronic is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Be aware that Higher Way Electronic is showing 2 warning signs in our investment analysis , and 1 of those doesn't sit too well with us...

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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