We Think Chenming Electronic Technology (TPE:3013) Can Manage Its Debt With Ease

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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, Chenming Electronic Technology Corporation (TPE:3013) does carry debt. But is this debt a concern to shareholders?

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. 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.

Check out our latest analysis for Chenming Electronic Technology

What Is Chenming Electronic Technology's Debt?

The image below, which you can click on for greater detail, shows that Chenming Electronic Technology had debt of NT$597.0m at the end of September 2020, a reduction from NT$627.0m over a year. However, because it has a cash reserve of NT$413.3m, its net debt is less, at about NT$183.7m.

A Look At Chenming Electronic Technology's Liabilities

The latest balance sheet data shows that Chenming Electronic Technology had liabilities of NT$1.94b due within a year, and liabilities of NT$314.6m falling due after that. Offsetting this, it had NT$413.3m in cash and NT$1.73b in receivables that were due within 12 months. So it has liabilities totalling NT$111.2m more than its cash and near-term receivables, combined.

Since publicly traded Chenming Electronic Technology shares are worth a total of NT$2.21b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Chenming Electronic Technology's net debt is only 0.35 times its EBITDA. And its EBIT covers its interest expense a whopping 39.1 times over. So we're pretty relaxed about its super-conservative use of debt. Even more impressive was the fact that Chenming Electronic Technology grew its EBIT by 145% over twelve months. That boost will make it even easier to pay down debt going forward. When analysing debt levels, the balance sheet is the obvious place to start. But it is Chenming Electronic Technology's earnings that will influence how the balance sheet holds up in the future. 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.

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 most recent three years, Chenming Electronic Technology recorded free cash flow worth 75% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

The good news is that Chenming Electronic Technology'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 EBIT growth rate is also very heartening. It looks Chenming Electronic Technology has no trouble standing on its own two feet, and it has no reason to fear its lenders. For investing nerds like us its balance sheet is almost charming. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should be aware of the 2 warning signs we've spotted with Chenming Electronic Technology .

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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This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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