Integrated Service Technology (GTSM:3289) Seems To Use Debt Quite Sensibly

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 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. We note that Integrated Service Technology, Inc. (GTSM:3289) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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.

Check out our latest analysis for Integrated Service Technology

What Is Integrated Service Technology's Debt?

You can click the graphic below for the historical numbers, but it shows that Integrated Service Technology had NT$3.08b of debt in September 2020, down from NT$5.05b, one year before. However, it does have NT$1.91b in cash offsetting this, leading to net debt of about NT$1.16b.

How Strong Is Integrated Service Technology's Balance Sheet?

We can see from the most recent balance sheet that Integrated Service Technology had liabilities of NT$2.88b falling due within a year, and liabilities of NT$1.68b due beyond that. Offsetting these obligations, it had cash of NT$1.91b as well as receivables valued at NT$1.32b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$1.33b.

While this might seem like a lot, it is not so bad since Integrated Service Technology has a market capitalization of NT$5.40b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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.

Integrated Service Technology has a very low debt to EBITDA ratio of 1.3 so it is strange to see weak interest coverage, with last year's EBIT being only 1.8 times the interest expense. So one way or the other, it's clear the debt levels are not trivial. Notably, Integrated Service Technology made a loss at the EBIT level, last year, but improved that to positive EBIT of NT$119m in the last twelve months. 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 Integrated Service Technology 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. Happily for any shareholders, Integrated Service Technology actually produced more free cash flow than EBIT over the last year. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

When it comes to the balance sheet, the standout positive for Integrated Service Technology was the fact that it seems able to convert EBIT to free cash flow confidently. However, our other observations weren't so heartening. To be specific, it seems about as good at covering its interest expense with its EBIT as wet socks are at keeping your feet warm. Considering this range of data points, we think Integrated Service Technology is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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. Like risks, for instance. Every company has them, and we've spotted 3 warning signs for Integrated Service Technology (of which 2 can't be ignored!) you should know about.

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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