Is Opto Tech (TPE:2340) Using Too Much Debt?

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 note that Opto Tech Corporation (TPE:2340) does have debt on its balance sheet. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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.

Check out our latest analysis for Opto Tech

How Much Debt Does Opto Tech Carry?

You can click the graphic below for the historical numbers, but it shows that Opto Tech had NT$1.02b of debt in September 2020, down from NT$1.07b, one year before. But it also has NT$3.38b in cash to offset that, meaning it has NT$2.36b net cash.

How Healthy Is Opto Tech's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Opto Tech had liabilities of NT$2.15b due within 12 months and liabilities of NT$1.24b due beyond that. On the other hand, it had cash of NT$3.38b and NT$1.67b worth of receivables due within a year. So it actually has NT$1.66b more liquid assets than total liabilities.

This excess liquidity suggests that Opto Tech is taking a careful approach to debt. Due to its strong net asset position, it is not likely to face issues with its lenders. Succinctly put, Opto Tech boasts net cash, so it's fair to say it does not have a heavy debt load!

But the bad news is that Opto Tech has seen its EBIT plunge 14% in the last twelve months. If that rate of decline in earnings continues, the company could find itself in a tight spot. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Opto Tech's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. While Opto Tech has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last three years, Opto Tech recorded free cash flow worth a fulsome 82% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that Opto Tech has net cash of NT$2.36b, as well as more liquid assets than liabilities. The cherry on top was that in converted 82% of that EBIT to free cash flow, bringing in NT$618m. So we don't think Opto Tech's use of debt is risky. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Opto Tech is showing 2 warning signs in our investment analysis , and 1 of those can't be ignored...

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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