Here's Why Cosmo Electronics (TPE:2466) Can Afford Some 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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Cosmo Electronics Corporation (TPE:2466) makes use of debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Cosmo Electronics

How Much Debt Does Cosmo Electronics Carry?

As you can see below, at the end of September 2020, Cosmo Electronics had NT$1.98b of debt, up from NT$1.72b a year ago. Click the image for more detail. On the flip side, it has NT$715.4m in cash leading to net debt of about NT$1.26b.

How Strong Is Cosmo Electronics' Balance Sheet?

We can see from the most recent balance sheet that Cosmo Electronics had liabilities of NT$667.0m falling due within a year, and liabilities of NT$1.82b due beyond that. On the other hand, it had cash of NT$715.4m and NT$692.5m worth of receivables due within a year. So its liabilities total NT$1.08b more than the combination of its cash and short-term receivables.

Cosmo Electronics has a market capitalization of NT$5.16b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. When analysing debt levels, the balance sheet is the obvious place to start. But it is Cosmo Electronics's earnings that will influence how the balance sheet holds up in the future. 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.

In the last year Cosmo Electronics had a loss before interest and tax, and actually shrunk its revenue by 50%, to NT$1.3b. That makes us nervous, to say the least.

Caveat Emptor

While Cosmo Electronics's falling revenue is about as heartwarming as a wet blanket, arguably its earnings before interest and tax (EBIT) loss is even less appealing. To be specific the EBIT loss came in at NT$149m. Considering that alongside the liabilities mentioned above does not give us much confidence that company should be using so much debt. Quite frankly we think the balance sheet is far from match-fit, although it could be improved with time. On the bright side, we note that trailing twelve month EBIT is worse than the free cash flow of NT$94m and the profit of NT$47m. So one might argue that there's still a chance it can get things on the right track. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 2 warning signs for Cosmo Electronics (1 shouldn't be ignored) 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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