Here's Why Promate ElectronicLtd (TPE:6189) Can Manage Its Debt Responsibly

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 Promate Electronic Co.,Ltd. (TPE:6189) does have debt on its balance sheet. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Promate ElectronicLtd

How Much Debt Does Promate ElectronicLtd Carry?

The image below, which you can click on for greater detail, shows that at September 2020 Promate ElectronicLtd had debt of NT$3.91b, up from NT$2.96b in one year. On the flip side, it has NT$2.07b in cash leading to net debt of about NT$1.85b.

How Strong Is Promate ElectronicLtd's Balance Sheet?

We can see from the most recent balance sheet that Promate ElectronicLtd had liabilities of NT$6.42b falling due within a year, and liabilities of NT$1.23b due beyond that. Offsetting these obligations, it had cash of NT$2.07b as well as receivables valued at NT$6.18b due within 12 months. So it actually has NT$598.7m more liquid assets than total liabilities.

This short term liquidity is a sign that Promate ElectronicLtd could probably pay off its debt with ease, as its balance sheet is far from stretched.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Promate ElectronicLtd's net debt to EBITDA ratio of about 1.9 suggests only moderate use of debt. And its strong interest cover of 13.1 times, makes us even more comfortable. If Promate ElectronicLtd can keep growing EBIT at last year's rate of 15% over the last year, then it will find its debt load easier to manage. When analysing debt levels, the balance sheet is the obvious place to start. But it is Promate ElectronicLtd'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 it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Promate ElectronicLtd reported free cash flow worth 5.7% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

The good news is that Promate ElectronicLtd's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But the stark truth is that we are concerned by its conversion of EBIT to free cash flow. Looking at all the aforementioned factors together, it strikes us that Promate ElectronicLtd can handle its debt fairly comfortably. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Promate ElectronicLtd is showing 2 warning signs in our investment analysis , and 1 of those is concerning...

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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