Hua Jung ComponentsLtd (GTSM:5328) Seems To Use Debt Rather Sparingly

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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 can see that Hua Jung Components Co.,Ltd. (GTSM:5328) does use debt in its business. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Hua Jung ComponentsLtd

How Much Debt Does Hua Jung ComponentsLtd Carry?

The image below, which you can click on for greater detail, shows that Hua Jung ComponentsLtd had debt of NT$280.0m at the end of September 2020, a reduction from NT$300.2m over a year. However, it does have NT$755.4m in cash offsetting this, leading to net cash of NT$475.4m.

A Look At Hua Jung ComponentsLtd's Liabilities

We can see from the most recent balance sheet that Hua Jung ComponentsLtd had liabilities of NT$466.4m falling due within a year, and liabilities of NT$42.7m due beyond that. Offsetting this, it had NT$755.4m in cash and NT$492.7m in receivables that were due within 12 months. So it actually has NT$739.0m more liquid assets than total liabilities.

This excess liquidity is a great indication that Hua Jung ComponentsLtd's balance sheet is almost as strong as Fort Knox. On this view, lenders should feel as safe as the beloved of a black-belt karate master. Simply put, the fact that Hua Jung ComponentsLtd has more cash than debt is arguably a good indication that it can manage its debt safely.

It was also good to see that despite losing money on the EBIT line last year, Hua Jung ComponentsLtd turned things around in the last 12 months, delivering and EBIT of NT$7.5m. There's no doubt that we learn most about debt from the balance sheet. But it is Hua Jung ComponentsLtd'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 Hua Jung ComponentsLtd 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. Happily for any shareholders, Hua Jung ComponentsLtd actually produced more free cash flow than EBIT over the last year. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that Hua Jung ComponentsLtd has net cash of NT$475.4m, as well as more liquid assets than liabilities. The cherry on top was that in converted 1,881% of that EBIT to free cash flow, bringing in NT$142m. So we don't think Hua Jung ComponentsLtd's use of debt is risky. 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 2 warning signs with Hua Jung ComponentsLtd , and understanding them should be part of your investment process.

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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