These 4 Measures Indicate That Lin Horn Technology (GTSM:5464) Is Using Debt Extensively

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. Importantly, Lin Horn Technology Co., Ltd. (GTSM:5464) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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.

See our latest analysis for Lin Horn Technology

What Is Lin Horn Technology's Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2020 Lin Horn Technology had NT$1.73b of debt, an increase on NT$1.47b, over one year. However, it also had NT$1.46b in cash, and so its net debt is NT$267.8m.

How Strong Is Lin Horn Technology's Balance Sheet?

We can see from the most recent balance sheet that Lin Horn Technology had liabilities of NT$2.07b falling due within a year, and liabilities of NT$457.9m due beyond that. Offsetting this, it had NT$1.46b in cash and NT$193.2m in receivables that were due within 12 months. So it has liabilities totalling NT$873.2m more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of NT$1.41b, so it does suggest shareholders should keep an eye on Lin Horn Technology's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Lin Horn Technology has net debt of just 0.26 times EBITDA, suggesting it could ramp leverage without breaking a sweat. And remarkably, despite having net debt, it actually received more in interest over the last twelve months than it had to pay. So it's fair to say it can handle debt like a hotshot teppanyaki chef handles cooking. In fact Lin Horn Technology's saving grace is its low debt levels, because its EBIT has tanked 22% in the last twelve months. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Lin Horn Technology will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Lin Horn Technology reported free cash flow worth 15% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

Mulling over Lin Horn Technology's attempt at (not) growing its EBIT, we're certainly not enthusiastic. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Once we consider all the factors above, together, it seems to us that Lin Horn Technology's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 4 warning signs for Lin Horn Technology (2 are significant) you should be aware of.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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