We Think Adda (GTSM:3071) Can Manage Its Debt With Ease

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.' 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 Adda Corporation (GTSM:3071) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. If things get really bad, the lenders can take control of the business. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, plenty of companies use debt to fund growth, without any negative consequences. 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 Adda

What Is Adda's Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Adda had NT$584.5m of debt, an increase on NT$390.1m, over one year. However, it does have NT$1.08b in cash offsetting this, leading to net cash of NT$494.7m.

How Healthy Is Adda's Balance Sheet?

We can see from the most recent balance sheet that Adda had liabilities of NT$1.23b falling due within a year, and liabilities of NT$234.6m due beyond that. Offsetting this, it had NT$1.08b in cash and NT$588.6m in receivables that were due within 12 months. So it actually has NT$207.3m more liquid assets than total liabilities.

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

Also positive, Adda grew its EBIT by 28% in the last year, and that should make it easier to pay down debt, going forward. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Adda'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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Adda may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last three years, Adda actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that Adda has net cash of NT$494.7m, as well as more liquid assets than liabilities. The cherry on top was that in converted 111% of that EBIT to free cash flow, bringing in NT$245m. So we don't think Adda's use of debt is risky. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Consider risks, for instance. Every company has them, and we've spotted 3 warning signs for Adda you should know about.

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. 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.
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