Chroma ATE (TPE:2360) Seems To Use Debt Quite Sensibly

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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Chroma ATE Inc. (TPE:2360) makes use of debt. But should shareholders be worried about its use of debt?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Chroma ATE

What Is Chroma ATE's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2020 Chroma ATE had debt of NT$6.24b, up from NT$4.86b in one year. On the flip side, it has NT$3.32b in cash leading to net debt of about NT$2.92b.

A Look At Chroma ATE's Liabilities

Zooming in on the latest balance sheet data, we can see that Chroma ATE had liabilities of NT$7.70b due within 12 months and liabilities of NT$3.91b due beyond that. Offsetting these obligations, it had cash of NT$3.32b as well as receivables valued at NT$5.66b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$2.63b.

Given Chroma ATE has a market capitalization of NT$84.1b, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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). 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).

Chroma ATE has a low net debt to EBITDA ratio of only 0.92. And its EBIT easily covers its interest expense, being 129 times the size. So we're pretty relaxed about its super-conservative use of debt. On top of that, Chroma ATE grew its EBIT by 48% over the last twelve months, and that growth will make it easier to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Chroma ATE's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Chroma ATE created free cash flow amounting to 16% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

Happily, Chroma ATE's impressive interest cover implies it has the upper hand on its debt. But truth be told we feel its conversion of EBIT to free cash flow does undermine this impression a bit. When we consider the range of factors above, it looks like Chroma ATE is pretty sensible with its use of debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. 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. To that end, you should be aware of the 2 warning signs we've spotted with Chroma ATE .

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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