Here's Why Harmony Electronics (GTSM:8182) Can Manage Its Debt Responsibly

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.' 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, Harmony Electronics Co. Ltd (GTSM:8182) does carry debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Harmony Electronics

What Is Harmony Electronics's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2020 Harmony Electronics had debt of NT$818.7m, up from NT$661.7m in one year. But it also has NT$1.14b in cash to offset that, meaning it has NT$323.0m net cash.

How Healthy Is Harmony Electronics's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Harmony Electronics had liabilities of NT$1.18b due within 12 months and liabilities of NT$607.4m due beyond that. Offsetting these obligations, it had cash of NT$1.14b as well as receivables valued at NT$823.5m due within 12 months. So it can boast NT$182.4m more liquid assets than total liabilities.

This short term liquidity is a sign that Harmony Electronics could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Harmony Electronics has more cash than debt is arguably a good indication that it can manage its debt safely.

On top of that, Harmony Electronics grew its EBIT by 49% over the last twelve months, and that growth will make it easier to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Harmony Electronics 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Harmony Electronics has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. In the last three years, Harmony Electronics created free cash flow amounting to 5.2% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Summing up

While it is always sensible to investigate a company's debt, in this case Harmony Electronics has NT$323.0m in net cash and a decent-looking balance sheet. And we liked the look of last year's 49% year-on-year EBIT growth. So we don't think Harmony Electronics's use of debt is risky. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 1 warning sign for Harmony Electronics you should be aware of.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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