The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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 note that Arcadyan Technology Corporation (TPE:3596) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, 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.
What Is Arcadyan Technology's Debt?
The image below, which you can click on for greater detail, shows that at December 2020 Arcadyan Technology had debt of NT$1.69b, up from NT$1.49b in one year. However, its balance sheet shows it holds NT$9.34b in cash, so it actually has NT$7.65b net cash.
How Healthy Is Arcadyan Technology's Balance Sheet?
The latest balance sheet data shows that Arcadyan Technology had liabilities of NT$15.4b due within a year, and liabilities of NT$1.48b falling due after that. Offsetting these obligations, it had cash of NT$9.34b as well as receivables valued at NT$7.07b due within 12 months. So it has liabilities totalling NT$430.8m more than its cash and near-term receivables, combined.
Having regard to Arcadyan Technology's size, it seems that its liquid assets are well balanced with its total liabilities. So while it's hard to imagine that the NT$23.3b company is struggling for cash, we still think it's worth monitoring its balance sheet. While it does have liabilities worth noting, Arcadyan Technology also has more cash than debt, so we're pretty confident it can manage its debt safely.
On top of that, Arcadyan Technology grew its EBIT by 32% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Arcadyan Technology can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Arcadyan Technology has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Happily for any shareholders, Arcadyan Technology actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
While it is always sensible to look at a company's total liabilities, it is very reassuring that Arcadyan Technology has NT$7.65b in net cash. And it impressed us with free cash flow of NT$2.8b, being 119% of its EBIT. So is Arcadyan Technology'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. Case in point: We've spotted 1 warning sign for Arcadyan Technology you should be aware of.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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