Is Scientech (TPE:3583) Using Too Much Debt?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. Importantly, Scientech Corporation (TPE:3583) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Scientech

What Is Scientech's Debt?

The image below, which you can click on for greater detail, shows that at September 2020 Scientech had debt of NT$469.1m, up from NT$11.6m in one year. However, it does have NT$1.18b in cash offsetting this, leading to net cash of NT$714.6m.

A Look At Scientech's Liabilities

The latest balance sheet data shows that Scientech had liabilities of NT$1.27b due within a year, and liabilities of NT$389.8m falling due after that. On the other hand, it had cash of NT$1.18b and NT$705.7m worth of receivables due within a year. So it actually has NT$228.8m more liquid assets than total liabilities.

This short term liquidity is a sign that Scientech could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Scientech has more cash than debt is arguably a good indication that it can manage its debt safely.

It is just as well that Scientech's load is not too heavy, because its EBIT was down 37% over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Scientech'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Scientech 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, Scientech produced sturdy free cash flow equating to 74% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that Scientech has net cash of NT$714.6m, as well as more liquid assets than liabilities. The cherry on top was that in converted 74% of that EBIT to free cash flow, bringing in NT$181m. So we don't have any problem with Scientech's use of debt. 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. Take risks, for example - Scientech has 2 warning signs we think you should be aware of.

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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