These 4 Measures Indicate That Hiwin Mikrosystem (TPE:4576) Is Using Debt Reasonably Well

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.' 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 the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Hiwin Mikrosystem

What Is Hiwin Mikrosystem's Net Debt?

As you can see below, Hiwin Mikrosystem had NT$1.30b of debt, at September 2020, which is about the same as the year before. You can click the chart for greater detail. However, it does have NT$464.5m in cash offsetting this, leading to net debt of about NT$831.6m.

A Look At Hiwin Mikrosystem's Liabilities

According to the last reported balance sheet, Hiwin Mikrosystem had liabilities of NT$1.07b due within 12 months, and liabilities of NT$985.6m due beyond 12 months. Offsetting these obligations, it had cash of NT$464.5m as well as receivables valued at NT$472.5m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$1.12b.

Of course, Hiwin Mikrosystem has a market capitalization of NT$19.8b, so these liabilities are probably manageable. 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

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. But its EBIT was about 13.0 times its interest expense, implying the company isn't really paying a high cost to maintain that level of debt. Even were the low cost to prove unsustainable, that is a good sign. 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. There's no doubt that we learn most about debt from the balance sheet. But it is Hiwin Mikrosystem'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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Hiwin Mikrosystem burned a lot of cash. 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

Hiwin Mikrosystem's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered were considerably better. In particular, we are dazzled with its interest cover. 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. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For example Hiwin Mikrosystem has 2 warning signs (and 1 which is a bit concerning) we think you should know about.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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