Here's Why Mercuries Data Systems (TWSE:2427) Has A Meaningful Debt Burden

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 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. We note that Mercuries Data Systems Ltd. (TWSE:2427) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Mercuries Data Systems

What Is Mercuries Data Systems's Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 Mercuries Data Systems had NT$2.16b of debt, an increase on NT$2.01b, over one year. However, because it has a cash reserve of NT$379.3m, its net debt is less, at about NT$1.78b.

How Healthy Is Mercuries Data Systems' Balance Sheet?

The latest balance sheet data shows that Mercuries Data Systems had liabilities of NT$2.17b due within a year, and liabilities of NT$1.54b falling due after that. On the other hand, it had cash of NT$379.3m and NT$1.47b worth of receivables due within a year. So it has liabilities totalling NT$1.86b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Mercuries Data Systems has a market capitalization of NT$6.96b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

As it happens Mercuries Data Systems has a fairly concerning net debt to EBITDA ratio of 5.2 but very strong interest coverage of 10.5. So either it has access to very cheap long term debt or that interest expense is going to grow! We saw Mercuries Data Systems grow its EBIT by 5.9% in the last twelve months. Whilst that hardly knocks our socks off it is a positive when it comes to debt. There's no doubt that we learn most about debt from the balance sheet. But it is Mercuries Data Systems'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Mercuries Data Systems burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

While Mercuries Data Systems's net debt to EBITDA makes us cautious about it, its track record of converting EBIT to free cash flow is no better. But at least its interest cover is a gleaming silver lining to those clouds. Taking the abovementioned factors together we do think Mercuries Data Systems's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 4 warning signs for Mercuries Data Systems you should be aware of, and 1 of them makes us a bit uncomfortable.

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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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com