Here's Why TSC Auto ID Technology (GTSM:3611) Can Manage Its Debt Responsibly

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 can see that TSC Auto ID Technology Co., Ltd. (GTSM:3611) does use debt in its business. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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.

See our latest analysis for TSC Auto ID Technology

How Much Debt Does TSC Auto ID Technology Carry?

As you can see below, at the end of September 2020, TSC Auto ID Technology had NT$2.10b of debt, up from NT$1.77b a year ago. Click the image for more detail. However, it does have NT$1.13b in cash offsetting this, leading to net debt of about NT$968.2m.

How Strong Is TSC Auto ID Technology's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that TSC Auto ID Technology had liabilities of NT$1.73b due within 12 months and liabilities of NT$1.91b due beyond that. Offsetting this, it had NT$1.13b in cash and NT$942.5m in receivables that were due within 12 months. So its liabilities total NT$1.56b more than the combination of its cash and short-term receivables.

Given TSC Auto ID Technology has a market capitalization of NT$9.05b, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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).

TSC Auto ID Technology has a low net debt to EBITDA ratio of only 0.91. And its EBIT easily covers its interest expense, being 51.8 times the size. So we're pretty relaxed about its super-conservative use of debt. On the other hand, TSC Auto ID Technology saw its EBIT drop by 7.7% in the last twelve months. That sort of decline, if sustained, will obviously make debt harder to handle. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if TSC Auto ID Technology can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. During the last three years, TSC Auto ID Technology 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, TSC Auto ID Technology's impressive interest cover implies it has the upper hand on its debt. But truth be told we feel its EBIT growth rate does undermine this impression a bit. When we consider the range of factors above, it looks like TSC Auto ID Technology is pretty sensible with its use of debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. 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 TSC Auto ID Technology you should know about.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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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