Does ACES Electronics (TPE:3605) Have A Healthy Balance Sheet?

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. As with many other companies ACES Electronics Co., Ltd. (TPE:3605) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for ACES Electronics

What Is ACES Electronics's Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2020 ACES Electronics had NT$2.63b of debt, an increase on NT$2.05b, over one year. However, it does have NT$2.10b in cash offsetting this, leading to net debt of about NT$531.5m.

A Look At ACES Electronics' Liabilities

According to the last reported balance sheet, ACES Electronics had liabilities of NT$3.72b due within 12 months, and liabilities of NT$2.01b due beyond 12 months. On the other hand, it had cash of NT$2.10b and NT$2.33b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$1.30b.

While this might seem like a lot, it is not so bad since ACES Electronics has a market capitalization of NT$6.03b, 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.

ACES Electronics's net debt is only 0.72 times its EBITDA. And its EBIT easily covers its interest expense, being 17.4 times the size. So we're pretty relaxed about its super-conservative use of debt. Also positive, ACES Electronics grew its EBIT by 30% in the last year, and that should make it easier to pay down debt, going forward. 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 ACES Electronics 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent three years, ACES Electronics recorded free cash flow of 23% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

ACES Electronics's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But truth be told we feel its conversion of EBIT to free cash flow does undermine this impression a bit. Taking all this data into account, it seems to us that ACES Electronics takes a pretty sensible approach to debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should be aware of the 1 warning sign we've spotted with ACES Electronics .

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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