These 4 Measures Indicate That Donpon Precision (GTSM:3290) Is Using Debt Safely

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.' 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 Donpon Precision Inc. (GTSM:3290) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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 step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Donpon Precision

What Is Donpon Precision's Net Debt?

The image below, which you can click on for greater detail, shows that at December 2020 Donpon Precision had debt of NT$934.6m, up from NT$789.9m in one year. However, it also had NT$756.7m in cash, and so its net debt is NT$177.9m.

A Look At Donpon Precision's Liabilities

Zooming in on the latest balance sheet data, we can see that Donpon Precision had liabilities of NT$1.24b due within 12 months and liabilities of NT$388.8m due beyond that. Offsetting this, it had NT$756.7m in cash and NT$904.9m in receivables that were due within 12 months. So it actually has NT$32.9m more liquid assets than total liabilities.

This surplus suggests that Donpon Precision has a conservative balance sheet, and could probably eliminate its debt without much difficulty.

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). 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).

Donpon Precision's net debt is only 0.87 times its EBITDA. And its EBIT easily covers its interest expense, being 18.3 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Another good sign is that Donpon Precision has been able to increase its EBIT by 22% in twelve months, making it easier to pay down debt. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Donpon Precision 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 it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Donpon Precision generated free cash flow amounting to a very robust 91% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Our View

Happily, Donpon Precision's impressive interest cover implies it has the upper hand on its debt. And the good news does not stop there, as its conversion of EBIT to free cash flow also supports that impression! Overall, we don't think Donpon Precision is taking any bad risks, as its debt load seems modest. So the balance sheet looks pretty healthy, to us. 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 3 warning signs for Donpon Precision you should be aware of, and 2 of them can't be ignored.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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