Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. We can see that Cameo Communications, Inc. (TPE:6142) does use debt in its business. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. When we think about a company's use of debt, we first look at cash and debt together.
See our latest analysis for Cameo Communications
What Is Cameo Communications's Net Debt?
The image below, which you can click on for greater detail, shows that at September 2020 Cameo Communications had debt of NT$1.61b, up from NT$1.07b in one year. However, because it has a cash reserve of NT$725.2m, its net debt is less, at about NT$883.5m.
How Healthy Is Cameo Communications's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Cameo Communications had liabilities of NT$1.91b due within 12 months and liabilities of NT$999.7m due beyond that. Offsetting these obligations, it had cash of NT$725.2m as well as receivables valued at NT$1.19b due within 12 months. So its liabilities total NT$996.4m more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since Cameo Communications has a market capitalization of NT$2.08b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Cameo Communications will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Over 12 months, Cameo Communications made a loss at the EBIT level, and saw its revenue drop to NT$3.0b, which is a fall of 13%. We would much prefer see growth.
Caveat Emptor
While Cameo Communications's falling revenue is about as heartwarming as a wet blanket, arguably its earnings before interest and tax (EBIT) loss is even less appealing. Indeed, it lost a very considerable NT$482m at the EBIT level. Considering that alongside the liabilities mentioned above does not give us much confidence that company should be using so much debt. So we think its balance sheet is a little strained, though not beyond repair. Another cause for caution is that is bled NT$691m in negative free cash flow over the last twelve months. So suffice it to say we consider the stock very risky. 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. Consider for instance, the ever-present spectre of investment risk. We've identified 3 warning signs with Cameo Communications (at least 2 which are significant) , and understanding them should be part of your investment process.
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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About TWSE:6142
Cameo Communications
Manufactures and sells networking system equipment and components primarily in Taiwan.
Flawless balance sheet and overvalued.