Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 Cypress Technology Co.,Ltd. (GTSM:3541) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest 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.
What Is Cypress TechnologyLtd's Debt?
As you can see below, Cypress TechnologyLtd had NT$256.0m of debt, at September 2020, which is about the same as the year before. You can click the chart for greater detail. However, it does have NT$416.0m in cash offsetting this, leading to net cash of NT$160.0m.
How Strong Is Cypress TechnologyLtd's Balance Sheet?
We can see from the most recent balance sheet that Cypress TechnologyLtd had liabilities of NT$611.4m falling due within a year, and liabilities of NT$29.4m due beyond that. Offsetting these obligations, it had cash of NT$416.0m as well as receivables valued at NT$288.3m due within 12 months. So it actually has NT$63.5m more liquid assets than total liabilities.
This surplus suggests that Cypress TechnologyLtd has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Succinctly put, Cypress TechnologyLtd boasts net cash, so it's fair to say it does not have a heavy debt load!
In fact Cypress TechnologyLtd's saving grace is its low debt levels, because its EBIT has tanked 24% in the last twelve months. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. There's no doubt that we learn most about debt from the balance sheet. But it is Cypress TechnologyLtd'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Cypress TechnologyLtd has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. During the last three years, Cypress TechnologyLtd generated free cash flow amounting to a very robust 83% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.
While we empathize with investors who find debt concerning, you should keep in mind that Cypress TechnologyLtd has net cash of NT$160.0m, as well as more liquid assets than liabilities. And it impressed us with free cash flow of NT$93m, being 83% of its EBIT. So we don't have any problem with Cypress TechnologyLtd's use of debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 3 warning signs with Cypress TechnologyLtd , and understanding them should be part of your investment process.
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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