Here's Why LEATEC Fine Ceramics (GTSM:6127) Has A Meaningful Debt Burden

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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, LEATEC Fine Ceramics Co., Ltd. (GTSM:6127) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for LEATEC Fine Ceramics

How Much Debt Does LEATEC Fine Ceramics Carry?

The image below, which you can click on for greater detail, shows that at September 2020 LEATEC Fine Ceramics had debt of NT$1.55b, up from NT$1.30b in one year. However, because it has a cash reserve of NT$111.8m, its net debt is less, at about NT$1.44b.

How Strong Is LEATEC Fine Ceramics' Balance Sheet?

According to the last reported balance sheet, LEATEC Fine Ceramics had liabilities of NT$922.8m due within 12 months, and liabilities of NT$976.1m due beyond 12 months. On the other hand, it had cash of NT$111.8m and NT$371.2m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$1.42b.

LEATEC Fine Ceramics has a market capitalization of NT$2.79b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

LEATEC Fine Ceramics shareholders face the double whammy of a high net debt to EBITDA ratio (11.7), and fairly weak interest coverage, since EBIT is just 0.54 times the interest expense. This means we'd consider it to have a heavy debt load. However, the silver lining was that LEATEC Fine Ceramics achieved a positive EBIT of NT$39m in the last twelve months, an improvement on the prior year's loss. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since LEATEC Fine Ceramics 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, LEATEC Fine Ceramics saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both LEATEC Fine Ceramics's interest cover and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But at least its EBIT growth rate is not so bad. Overall, it seems to us that LEATEC Fine Ceramics's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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 example - LEATEC Fine Ceramics has 2 warning signs we think you should be aware of.

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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