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.' 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, Ecocera Optronics Co., Ltd. (GTSM:6597) does carry debt. But is this debt a concern to shareholders?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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 think about a company's use of debt, we first look at cash and debt together.
What Is Ecocera Optronics's Net Debt?
The chart below, which you can click on for greater detail, shows that Ecocera Optronics had NT$244.4m in debt in June 2020; about the same as the year before. However, because it has a cash reserve of NT$34.7m, its net debt is less, at about NT$209.8m.
How Healthy Is Ecocera Optronics's Balance Sheet?
The latest balance sheet data shows that Ecocera Optronics had liabilities of NT$354.5m due within a year, and liabilities of NT$20.0m falling due after that. On the other hand, it had cash of NT$34.7m and NT$145.1m worth of receivables due within a year. So it has liabilities totalling NT$194.7m more than its cash and near-term receivables, combined.
This deficit is considerable relative to its market capitalization of NT$292.1m, so it does suggest shareholders should keep an eye on Ecocera Optronics's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Ecocera Optronics 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.
Over 12 months, Ecocera Optronics made a loss at the EBIT level, and saw its revenue drop to NT$384m, which is a fall of 7.1%. That's not what we would hope to see.
Over the last twelve months Ecocera Optronics produced an earnings before interest and tax (EBIT) loss. Indeed, it lost NT$28m at the EBIT level. When we look at that and recall the liabilities on its balance sheet, relative to cash, it seems unwise to us for the company to have any debt. Quite frankly we think the balance sheet is far from match-fit, although it could be improved with time. Another cause for caution is that is bled NT$672k in negative free cash flow over the last twelve months. So suffice it to say we do consider the stock to be risky. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 2 warning signs for Ecocera Optronics (1 is potentially serious!) that you should be aware of before investing here.
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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