ABC Taiwan Electronics (GTSM:3236) Seems To Use Debt Quite Sensibly

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 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. Importantly, ABC Taiwan Electronics Corp. (GTSM:3236) does carry debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for ABC Taiwan Electronics

How Much Debt Does ABC Taiwan Electronics Carry?

The image below, which you can click on for greater detail, shows that at September 2020 ABC Taiwan Electronics had debt of NT$804.2m, up from NT$725.6m in one year. On the flip side, it has NT$672.6m in cash leading to net debt of about NT$131.6m.

How Strong Is ABC Taiwan Electronics's Balance Sheet?

The latest balance sheet data shows that ABC Taiwan Electronics had liabilities of NT$853.0m due within a year, and liabilities of NT$451.9m falling due after that. Offsetting these obligations, it had cash of NT$672.6m as well as receivables valued at NT$413.6m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$218.8m.

Given ABC Taiwan Electronics has a market capitalization of NT$2.28b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

ABC Taiwan Electronics has a low net debt to EBITDA ratio of only 0.55. And its EBIT covers its interest expense a whopping 37.8 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Also good is that ABC Taiwan Electronics grew its EBIT at 10% over the last year, further increasing its ability to manage debt. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since ABC Taiwan 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. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, ABC Taiwan Electronics saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Based on what we've seen ABC Taiwan Electronics is not finding it easy, given its conversion of EBIT to free cash flow, but the other factors we considered give us cause to be optimistic. In particular, we are dazzled with its interest cover. Considering this range of data points, we think ABC Taiwan Electronics is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that ABC Taiwan Electronics is showing 4 warning signs in our investment analysis , and 1 of those doesn't sit too well with us...

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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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