Here's Why Hi Sharp Electronics (GTSM:3128) Has A Meaningful Debt Burden

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.' 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 Hi Sharp Electronics Co., Ltd. (GTSM:3128) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Hi Sharp Electronics

What Is Hi Sharp Electronics's Debt?

The image below, which you can click on for greater detail, shows that at September 2020 Hi Sharp Electronics had debt of NT$246.0m, up from NT$188.3m in one year. On the flip side, it has NT$49.9m in cash leading to net debt of about NT$196.0m.

How Healthy Is Hi Sharp Electronics' Balance Sheet?

We can see from the most recent balance sheet that Hi Sharp Electronics had liabilities of NT$283.1m falling due within a year, and liabilities of NT$126.9m due beyond that. Offsetting these obligations, it had cash of NT$49.9m as well as receivables valued at NT$158.6m due within 12 months. So its liabilities total NT$201.4m more than the combination of its cash and short-term receivables.

Hi Sharp Electronics has a market capitalization of NT$809.2m, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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.

As it happens Hi Sharp Electronics has a fairly concerning net debt to EBITDA ratio of 5.1 but very strong interest coverage of 13.2. So either it has access to very cheap long term debt or that interest expense is going to grow! Sadly, Hi Sharp Electronics's EBIT actually dropped 7.0% in the last year. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. 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 Hi Sharp 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.

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. Over the last three years, Hi Sharp Electronics recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

Neither Hi Sharp Electronics's ability to convert EBIT to free cash flow nor its net debt to EBITDA 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 Hi Sharp 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. 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. These risks can be hard to spot. Every company has them, and we've spotted 4 warning signs for Hi Sharp Electronics (of which 1 doesn't sit too well with us!) you should know about.

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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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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