Is Sercomm (TPE:5388) Using Too Much Debt?

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that Sercomm Corporation (TPE:5388) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth 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 Sercomm

How Much Debt Does Sercomm Carry?

The image below, which you can click on for greater detail, shows that at September 2020 Sercomm had debt of NT$5.17b, up from NT$3.55b in one year. But it also has NT$6.65b in cash to offset that, meaning it has NT$1.48b net cash.

How Strong Is Sercomm's Balance Sheet?

We can see from the most recent balance sheet that Sercomm had liabilities of NT$16.5b falling due within a year, and liabilities of NT$4.02b due beyond that. Offsetting these obligations, it had cash of NT$6.65b as well as receivables valued at NT$7.85b due within 12 months. So its liabilities total NT$6.02b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Sercomm has a market capitalization of NT$19.7b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt. Despite its noteworthy liabilities, Sercomm boasts net cash, so it's fair to say it does not have a heavy debt load!

On the other hand, Sercomm saw its EBIT drop by 7.4% in the last twelve months. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Sercomm can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. Sercomm may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. In the last three years, Sercomm's free cash flow amounted to 28% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Summing up

Although Sercomm's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of NT$1.48b. So we don't have any problem with Sercomm's use of debt. 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. Be aware that Sercomm is showing 3 warning signs in our investment analysis , and 2 of those are a bit unpleasant...

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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