Is Hiwin Mikrosystem (TPE:4576) A Risky Investment?

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.' 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. As with many other companies Hiwin Mikrosystem Corp. (TPE:4576) makes use of debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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 step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Hiwin Mikrosystem

What Is Hiwin Mikrosystem's Debt?

The chart below, which you can click on for greater detail, shows that Hiwin Mikrosystem had NT$1.30b in debt in September 2020; about the same as the year before. However, because it has a cash reserve of NT$464.5m, its net debt is less, at about NT$831.6m.

How Healthy Is Hiwin Mikrosystem's Balance Sheet?

We can see from the most recent balance sheet that Hiwin Mikrosystem had liabilities of NT$1.07b falling due within a year, and liabilities of NT$985.6m due beyond that. On the other hand, it had cash of NT$464.5m and NT$472.5m worth of receivables due within a year. So it has liabilities totalling NT$1.12b more than its cash and near-term receivables, combined.

Given Hiwin Mikrosystem has a market capitalization of NT$9.29b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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).

Hiwin Mikrosystem has a debt to EBITDA ratio of 3.2, which signals significant debt, but is still pretty reasonable for most types of business. However, its interest coverage of 13.0 is very high, suggesting that the interest expense on the debt is currently quite low. It is well worth noting that Hiwin Mikrosystem's EBIT shot up like bamboo after rain, gaining 54% in the last twelve months. That'll make it easier to manage its debt. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Hiwin Mikrosystem will need earnings to service that debt. 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.

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. Over the last three years, Hiwin Mikrosystem saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

Based on what we've seen Hiwin Mikrosystem is not finding it easy, given its conversion of EBIT to free cash flow, but the other factors we considered give us cause to be optimistic. There's no doubt that its ability to to cover its interest expense with its EBIT is pretty flash. Considering this range of data points, we think Hiwin Mikrosystem is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 1 warning sign for Hiwin Mikrosystem that you should be aware of.

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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