Does Ability Opto-Electronics TechnologyLtd (GTSM:3362) Have A Healthy Balance Sheet?

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 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 can see that Ability Opto-Electronics Technology Co.,Ltd. (GTSM:3362) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Ability Opto-Electronics TechnologyLtd

What Is Ability Opto-Electronics TechnologyLtd's Debt?

As you can see below, at the end of September 2020, Ability Opto-Electronics TechnologyLtd had NT$753.3m of debt, up from NT$379.4m a year ago. Click the image for more detail. However, it also had NT$459.7m in cash, and so its net debt is NT$293.6m.

How Healthy Is Ability Opto-Electronics TechnologyLtd's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Ability Opto-Electronics TechnologyLtd had liabilities of NT$1.22b due within 12 months and liabilities of NT$347.6m due beyond that. Offsetting this, it had NT$459.7m in cash and NT$1.13b in receivables that were due within 12 months. So its total liabilities are just about perfectly matched by its shorter-term, liquid assets.

Having regard to Ability Opto-Electronics TechnologyLtd's size, it seems that its liquid assets are well balanced with its total liabilities. So it's very unlikely that the NT$3.81b company is short on cash, but still worth keeping an eye on the balance sheet.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its 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).

While Ability Opto-Electronics TechnologyLtd's low debt to EBITDA ratio of 0.78 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 5.0 times last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Sadly, Ability Opto-Electronics TechnologyLtd's EBIT actually dropped 8.1% in the last year. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. 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 Ability Opto-Electronics TechnologyLtd 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 clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Ability Opto-Electronics TechnologyLtd burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Ability Opto-Electronics TechnologyLtd's struggle to convert EBIT to free cash flow had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. For example its net debt to EBITDA was refreshing. Looking at all the angles mentioned above, it does seem to us that Ability Opto-Electronics TechnologyLtd is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Ability Opto-Electronics TechnologyLtd you should know about.

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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