Is Alltek Technology (TPE:3209) A Risky Investment?

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Alltek Technology Corporation (TPE:3209) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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.

Check out our latest analysis for Alltek Technology

What Is Alltek Technology's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Alltek Technology had NT$4.36b of debt in December 2020, down from NT$4.86b, one year before. However, it also had NT$710.7m in cash, and so its net debt is NT$3.65b.

A Look At Alltek Technology's Liabilities

The latest balance sheet data shows that Alltek Technology had liabilities of NT$8.16b due within a year, and liabilities of NT$988.8m falling due after that. Offsetting these obligations, it had cash of NT$710.7m as well as receivables valued at NT$6.06b due within 12 months. So its liabilities total NT$2.38b more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Alltek Technology is worth NT$5.50b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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).

Alltek Technology has a rather high debt to EBITDA ratio of 6.1 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 4.6 times, suggesting it can responsibly service its obligations. We saw Alltek Technology grow its EBIT by 2.8% in the last twelve months. Whilst that hardly knocks our socks off it is a positive when it comes to debt. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Alltek Technology 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Happily for any shareholders, Alltek 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

Alltek Technology's net debt to EBITDA was a real negative on this analysis, although the other factors we considered were considerably better. In particular, we are dazzled with its conversion of EBIT to free cash flow. When we consider all the factors mentioned above, we do feel a bit cautious about Alltek Technology's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 3 warning signs for Alltek Technology you should be aware of.

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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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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