Is Aten International (TPE:6277) A Risky Investment?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. Importantly, Aten International Co., Ltd (TPE:6277) does carry debt. But the more important question is: how much risk is that debt creating?

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. 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.

Check out our latest analysis for Aten International

How Much Debt Does Aten International Carry?

The image below, which you can click on for greater detail, shows that at September 2020 Aten International had debt of NT$768.6m, up from NT$722.9m in one year. But on the other hand it also has NT$2.87b in cash, leading to a NT$2.10b net cash position.

How Healthy Is Aten International's Balance Sheet?

According to the last reported balance sheet, Aten International had liabilities of NT$2.22b due within 12 months, and liabilities of NT$549.2m due beyond 12 months. Offsetting this, it had NT$2.87b in cash and NT$691.0m in receivables that were due within 12 months. So it can boast NT$794.9m more liquid assets than total liabilities.

This surplus suggests that Aten International has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that Aten International has more cash than debt is arguably a good indication that it can manage its debt safely.

But the bad news is that Aten International has seen its EBIT plunge 17% in the last twelve months. If that rate of decline in earnings continues, the company could find itself in a tight spot. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Aten International can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Aten International has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last three years, Aten International reported free cash flow worth 14% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that Aten International has net cash of NT$2.10b, as well as more liquid assets than liabilities. So we don't have any problem with Aten International's use of debt. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Be aware that Aten International is showing 3 warning signs in our investment analysis , and 2 of those don't sit too well with us...

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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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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