Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 can see that Everlight Electronics Co., Ltd. (TPE:2393) does use debt in its business. But should shareholders be worried about its use of debt?
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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does Everlight Electronics Carry?
The image below, which you can click on for greater detail, shows that Everlight Electronics had debt of NT$3.67b at the end of September 2020, a reduction from NT$4.07b over a year. However, its balance sheet shows it holds NT$8.99b in cash, so it actually has NT$5.32b net cash.
How Healthy Is Everlight Electronics' Balance Sheet?
The latest balance sheet data shows that Everlight Electronics had liabilities of NT$10.8b due within a year, and liabilities of NT$709.8m falling due after that. Offsetting these obligations, it had cash of NT$8.99b as well as receivables valued at NT$6.69b due within 12 months. So it can boast NT$4.15b more liquid assets than total liabilities.
This excess liquidity suggests that Everlight Electronics is taking a careful approach to debt. Because it has plenty of assets, it is unlikely to have trouble with its lenders. Succinctly put, Everlight Electronics boasts net cash, so it's fair to say it does not have a heavy debt load!
In addition to that, we're happy to report that Everlight Electronics has boosted its EBIT by 91%, thus reducing the spectre of future debt repayments. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Everlight Electronics's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Everlight Electronics 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. Happily for any shareholders, Everlight Electronics actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
While we empathize with investors who find debt concerning, you should keep in mind that Everlight Electronics has net cash of NT$5.32b, as well as more liquid assets than liabilities. The cherry on top was that in converted 169% of that EBIT to free cash flow, bringing in NT$1.7b. When it comes to Everlight Electronics's debt, we sufficiently relaxed that our mind turns to the jacuzzi. 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. Case in point: We've spotted 1 warning sign for Everlight Electronics you should be aware of.
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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