Lotes (TPE:3533) Seems To Use Debt Rather Sparingly

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.' 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. We can see that Lotes Co., Ltd (TPE:3533) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. If things get really bad, the lenders can take control of the business. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Lotes

What Is Lotes's Debt?

The image below, which you can click on for greater detail, shows that at September 2020 Lotes had debt of NT$782.0m, up from NT$286.7m in one year. But on the other hand it also has NT$4.04b in cash, leading to a NT$3.26b net cash position.

How Strong Is Lotes's Balance Sheet?

According to the last reported balance sheet, Lotes had liabilities of NT$5.32b due within 12 months, and liabilities of NT$273.6m due beyond 12 months. On the other hand, it had cash of NT$4.04b and NT$6.90b worth of receivables due within a year. So it actually has NT$5.35b more liquid assets than total liabilities.

This surplus suggests that Lotes has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that Lotes has more cash than debt is arguably a good indication that it can manage its debt safely.

In addition to that, we're happy to report that Lotes has boosted its EBIT by 51%, thus reducing the spectre of future debt repayments. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Lotes can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Lotes may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last three years, Lotes produced sturdy free cash flow equating to 65% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that Lotes has net cash of NT$3.26b, as well as more liquid assets than liabilities. And it impressed us with its EBIT growth of 51% over the last year. So is Lotes's debt a risk? It doesn't seem so to us. 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 be aware of the 1 warning sign we've spotted with Lotes .

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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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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