Laser Tek TaiwanLtd (GTSM:6207) Seems To Use Debt Quite Sensibly

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. We note that Laser Tek Taiwan Co.,Ltd (GTSM:6207) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, 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.

View our latest analysis for Laser Tek TaiwanLtd

What Is Laser Tek TaiwanLtd's Net Debt?

As you can see below, at the end of September 2020, Laser Tek TaiwanLtd had NT$1.94b of debt, up from NT$1.42b a year ago. Click the image for more detail. However, because it has a cash reserve of NT$1.22b, its net debt is less, at about NT$722.0m.

A Look At Laser Tek TaiwanLtd's Liabilities

We can see from the most recent balance sheet that Laser Tek TaiwanLtd had liabilities of NT$1.84b falling due within a year, and liabilities of NT$461.4m due beyond that. On the other hand, it had cash of NT$1.22b and NT$508.8m worth of receivables due within a year. So it has liabilities totalling NT$575.1m more than its cash and near-term receivables, combined.

This deficit isn't so bad because Laser Tek TaiwanLtd is worth NT$2.41b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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.

As it happens Laser Tek TaiwanLtd has a fairly concerning net debt to EBITDA ratio of 5.6 but very strong interest coverage of 1k. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. If Laser Tek TaiwanLtd can keep growing EBIT at last year's rate of 17% over the last year, then it will find its debt load easier to manage. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Laser Tek TaiwanLtd will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Laser Tek TaiwanLtd recorded free cash flow worth a fulsome 92% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Our View

Happily, Laser Tek TaiwanLtd's impressive interest cover implies it has the upper hand on its debt. But the stark truth is that we are concerned by its net debt to EBITDA. When we consider the range of factors above, it looks like Laser Tek TaiwanLtd is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. 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. Take risks, for example - Laser Tek TaiwanLtd has 5 warning signs (and 3 which are a bit unpleasant) we think 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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