Is EDIMAX Technology (TPE:3047) Using Too Much Debt?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. We can see that EDIMAX Technology Co., Ltd. (TPE:3047) does use debt in its business. But the more important question is: how much risk is that debt creating?

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. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for EDIMAX Technology

What Is EDIMAX Technology's Net Debt?

The chart below, which you can click on for greater detail, shows that EDIMAX Technology had NT$2.32b in debt in September 2020; about the same as the year before. However, it does have NT$1.99b in cash offsetting this, leading to net debt of about NT$330.6m.

A Look At EDIMAX Technology's Liabilities

The latest balance sheet data shows that EDIMAX Technology had liabilities of NT$3.22b due within a year, and liabilities of NT$1.50b falling due after that. Offsetting these obligations, it had cash of NT$1.99b as well as receivables valued at NT$1.54b due within 12 months. So it has liabilities totalling NT$1.19b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since EDIMAX Technology has a market capitalization of NT$2.27b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

EDIMAX Technology's net debt is only 0.62 times its EBITDA. And its EBIT easily covers its interest expense, being 19.3 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Better yet, EDIMAX Technology grew its EBIT by 214% last year, which is an impressive improvement. If maintained that growth will make the debt even more manageable in the years ahead. There's no doubt that we learn most about debt from the balance sheet. But it is EDIMAX Technology's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. Happily for any shareholders, EDIMAX Technology actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

The good news is that EDIMAX Technology's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But, on a more sombre note, we are a little concerned by its level of total liabilities. Zooming out, EDIMAX Technology seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. To that end, you should learn about the 4 warning signs we've spotted with EDIMAX Technology (including 1 which is significant) .

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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