JMC Electronics (TPE:6552) Takes On Some Risk With Its Use Of Debt

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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies JMC Electronics Co., Ltd. (TPE:6552) makes use of debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for JMC Electronics

How Much Debt Does JMC Electronics Carry?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 JMC Electronics had NT$1.24b of debt, an increase on NT$516.3m, over one year. However, it does have NT$820.1m in cash offsetting this, leading to net debt of about NT$421.7m.

How Strong Is JMC Electronics' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that JMC Electronics had liabilities of NT$1.08b due within 12 months and liabilities of NT$994.3m due beyond that. Offsetting this, it had NT$820.1m in cash and NT$406.0m in receivables that were due within 12 months. So it has liabilities totalling NT$848.9m more than its cash and near-term receivables, combined.

Given JMC Electronics has a market capitalization of NT$4.45b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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.

JMC Electronics has a low debt to EBITDA ratio of only 0.77. And remarkably, despite having net debt, it actually received more in interest over the last twelve months than it had to pay. So it's fair to say it can handle debt like a hotshot teppanyaki chef handles cooking. In fact JMC Electronics's saving grace is its low debt levels, because its EBIT has tanked 64% in the last twelve months. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. 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 JMC Electronics 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 company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. During the last three years, JMC Electronics burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Neither JMC Electronics's ability to grow its EBIT nor its conversion of EBIT to free cash flow gave us confidence in its ability to take on more debt. But its interest cover tells a very different story, and suggests some resilience. Taking the abovementioned factors together we do think JMC Electronics's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. To that end, you should be aware of the 3 warning signs we've spotted with JMC Electronics .

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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