Castles Technology (TPE:5258) Takes On Some Risk With Its Use Of 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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Castles Technology Co., Ltd. (TPE:5258) makes use of debt. But the real question is whether this debt is making the company risky.

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. If things get really bad, the lenders can take control of the business. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.

Check out our latest analysis for Castles Technology

What Is Castles Technology's Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Castles Technology had NT$1.14b of debt, an increase on NT$897.1m, over one year. However, it does have NT$513.7m in cash offsetting this, leading to net debt of about NT$627.7m.

A Look At Castles Technology's Liabilities

The latest balance sheet data shows that Castles Technology had liabilities of NT$1.81b due within a year, and liabilities of NT$411.3m falling due after that. Offsetting this, it had NT$513.7m in cash and NT$757.9m in receivables that were due within 12 months. So its liabilities total NT$953.9m more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Castles Technology is worth NT$1.95b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its 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).

Castles Technology's net debt to EBITDA ratio of about 1.7 suggests only moderate use of debt. And its strong interest cover of 1k times, makes us even more comfortable. It was also good to see that despite losing money on the EBIT line last year, Castles Technology turned things around in the last 12 months, delivering and EBIT of NT$319m. When analysing debt levels, the balance sheet is the obvious place to start. But it is Castles Technology's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Castles Technology 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

Castles Technology's conversion of EBIT to free cash flow and level of total liabilities definitely weigh on it, in our esteem. But its interest cover tells a very different story, and suggests some resilience. When we consider all the factors discussed, it seems to us that Castles Technology is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. Like risks, for instance. Every company has them, and we've spotted 4 warning signs for Castles Technology (of which 3 can't be ignored!) you should know about.

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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