Leo Systems (GTSM:5410) Seems To Use Debt Rather Sparingly

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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Leo Systems, Inc. (GTSM:5410) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. 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.

Check out our latest analysis for Leo Systems

How Much Debt Does Leo Systems Carry?

You can click the graphic below for the historical numbers, but it shows that Leo Systems had NT$125.4m of debt in September 2020, down from NT$180.0m, one year before. However, it does have NT$227.9m in cash offsetting this, leading to net cash of NT$102.5m.

A Look At Leo Systems' Liabilities

Zooming in on the latest balance sheet data, we can see that Leo Systems had liabilities of NT$1.11b due within 12 months and liabilities of NT$80.7m due beyond that. On the other hand, it had cash of NT$227.9m and NT$985.0m worth of receivables due within a year. So it actually has NT$24.7m more liquid assets than total liabilities.

Having regard to Leo Systems' size, it seems that its liquid assets are well balanced with its total liabilities. So while it's hard to imagine that the NT$1.78b company is struggling for cash, we still think it's worth monitoring its balance sheet. Succinctly put, Leo Systems boasts net cash, so it's fair to say it does not have a heavy debt load!

Fortunately, Leo Systems grew its EBIT by 5.6% in the last year, making that debt load look even more manageable. When analysing debt levels, the balance sheet is the obvious place to start. But it is Leo Systems'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Leo Systems 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, Leo Systems generated free cash flow amounting to a very robust 86% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that Leo Systems has net cash of NT$102.5m, as well as more liquid assets than liabilities. The cherry on top was that in converted 86% of that EBIT to free cash flow, bringing in NT$247m. So is Leo Systems's debt a risk? It doesn't seem so to us. 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. For example, we've discovered 1 warning sign for Leo Systems that you should be aware of before investing here.

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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