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.' 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. We can see that Acme Electronics Corporation (GTSM:8121) does use debt in its business. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.
What Is Acme Electronics's Net Debt?
The chart below, which you can click on for greater detail, shows that Acme Electronics had NT$1.26b in debt in September 2020; about the same as the year before. However, it also had NT$703.2m in cash, and so its net debt is NT$561.8m.
How Strong Is Acme Electronics' Balance Sheet?
The latest balance sheet data shows that Acme Electronics had liabilities of NT$1.12b due within a year, and liabilities of NT$554.7m falling due after that. On the other hand, it had cash of NT$703.2m and NT$525.4m worth of receivables due within a year. So its liabilities total NT$445.2m more than the combination of its cash and short-term receivables.
Since publicly traded Acme Electronics shares are worth a total of NT$3.30b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
We'd say that Acme Electronics's moderate net debt to EBITDA ratio ( being 2.2), indicates prudence when it comes to debt. And its commanding EBIT of 12.6 times its interest expense, implies the debt load is as light as a peacock feather. We also note that Acme Electronics improved its EBIT from a last year's loss to a positive NT$69m. 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 Acme Electronics 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Happily for any shareholders, Acme Electronics actually produced more free cash flow than EBIT over the last year. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
The good news is that Acme Electronics's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And that's just the beginning of the good news since its conversion of EBIT to free cash flow is also very heartening. When we consider the range of factors above, it looks like Acme Electronics is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. Even though Acme Electronics lost money on the bottom line, its positive EBIT suggests the business itself has potential. So you might want to check out how earnings have been trending over the last few years.
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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