Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 ABC Taiwan Electronics Corp. (GTSM:3236) 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?
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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does ABC Taiwan Electronics Carry?
You can click the graphic below for the historical numbers, but it shows that as of September 2020 ABC Taiwan Electronics had NT$804.2m of debt, an increase on NT$725.6m, over one year. However, it also had NT$672.6m in cash, and so its net debt is NT$131.6m.
How Strong Is ABC Taiwan Electronics' Balance Sheet?
According to the last reported balance sheet, ABC Taiwan Electronics had liabilities of NT$853.0m due within 12 months, and liabilities of NT$451.9m due beyond 12 months. On the other hand, it had cash of NT$672.6m and NT$413.6m worth of receivables due within a year. So it has liabilities totalling NT$218.8m more than its cash and near-term receivables, combined.
Of course, ABC Taiwan Electronics has a market capitalization of NT$2.51b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
ABC Taiwan Electronics has a low net debt to EBITDA ratio of only 0.55. And its EBIT easily covers its interest expense, being 37.8 times the size. So we're pretty relaxed about its super-conservative use of debt. And we also note warmly that ABC Taiwan Electronics grew its EBIT by 10% last year, making its debt load easier to handle. When analysing debt levels, the balance sheet is the obvious place to start. But it is ABC Taiwan Electronics'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, while the tax-man may adore accounting profits, lenders only accept 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 investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
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. There's no doubt that its ability to to cover its interest expense with its EBIT is pretty flash. When we consider all the elements mentioned above, it seems to us that ABC Taiwan Electronics is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Be aware that ABC Taiwan Electronics is showing 4 warning signs in our investment analysis , and 1 of those is a bit concerning...
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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