Hi Sharp Electronics (GTSM:3128) Seems To Use Debt Quite Sensibly

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. We note that Hi Sharp Electronics Co., Ltd. (GTSM:3128) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Hi Sharp Electronics

What Is Hi Sharp Electronics's Debt?

As you can see below, at the end of March 2020, Hi Sharp Electronics had NT$191.4m of debt, up from NT$161.1m a year ago. Click the image for more detail. However, it does have NT$57.3m in cash offsetting this, leading to net debt of about NT$134.1m.

How Strong Is Hi Sharp Electronics's Balance Sheet?

We can see from the most recent balance sheet that Hi Sharp Electronics had liabilities of NT$243.9m falling due within a year, and liabilities of NT$135.4m due beyond that. Offsetting these obligations, it had cash of NT$57.3m as well as receivables valued at NT$161.3m due within 12 months. So its liabilities total NT$160.6m more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Hi Sharp Electronics is worth NT$531.2m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. 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.

Hi Sharp Electronics has a debt to EBITDA ratio of 3.3, which signals significant debt, but is still pretty reasonable for most types of business. But its EBIT was about 18.9 times its interest expense, implying the company isn't really paying a high cost to maintain that level of debt. Even were the low cost to prove unsustainable, that is a good sign. Importantly, Hi Sharp Electronics grew its EBIT by 87% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is Hi Sharp Electronics's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Hi Sharp Electronics produced sturdy free cash flow equating to 67% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Happily, Hi Sharp Electronics's impressive interest cover implies it has the upper hand on its debt. But truth be told we feel its net debt to EBITDA does undermine this impression a bit. Taking all this data into account, it seems to us that Hi Sharp Electronics takes a pretty sensible approach to debt. While that brings some risk, it can also enhance returns for shareholders. 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. Case in point: We've spotted 2 warning signs for Hi Sharp Electronics you should be aware of.

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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