Is Advanced Power Electronics (TPE:8261) Using Too Much 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 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. As with many other companies Advanced Power Electronics Co., Ltd. (TPE:8261) makes use of debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Advanced Power Electronics

What Is Advanced Power Electronics's Debt?

As you can see below, Advanced Power Electronics had NT$190.0m of debt at September 2020, down from NT$330.0m a year prior. But it also has NT$381.3m in cash to offset that, meaning it has NT$191.3m net cash.

How Healthy Is Advanced Power Electronics' Balance Sheet?

We can see from the most recent balance sheet that Advanced Power Electronics had liabilities of NT$913.4m falling due within a year, and liabilities of NT$141.0k due beyond that. On the other hand, it had cash of NT$381.3m and NT$800.1m worth of receivables due within a year. So it can boast NT$267.8m more liquid assets than total liabilities.

This surplus suggests that Advanced Power Electronics has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that Advanced Power Electronics has more cash than debt is arguably a good indication that it can manage its debt safely.

Even more impressive was the fact that Advanced Power Electronics grew its EBIT by 102% over twelve months. If maintained that growth will make the debt even more manageable in the years ahead. 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 Advanced Power Electronics will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Advanced Power 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. Looking at the most recent three years, Advanced Power Electronics recorded free cash flow of 38% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that Advanced Power Electronics has net cash of NT$191.3m, as well as more liquid assets than liabilities. And it impressed us with its EBIT growth of 102% over the last year. So we don't think Advanced Power Electronics's use of debt is risky. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Be aware that Advanced Power Electronics is showing 1 warning sign in our investment analysis , 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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