These 4 Measures Indicate That Posiflex Technology (TPE:8114) Is Using Debt Extensively

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. As with many other companies Posiflex Technology, Inc. (TPE:8114) makes use of debt. But should shareholders be worried about its use of debt?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Posiflex Technology

How Much Debt Does Posiflex Technology Carry?

As you can see below, Posiflex Technology had NT$8.15b of debt, at September 2020, which is about the same as the year before. You can click the chart for greater detail. However, it also had NT$2.07b in cash, and so its net debt is NT$6.08b.

How Healthy Is Posiflex Technology's Balance Sheet?

We can see from the most recent balance sheet that Posiflex Technology had liabilities of NT$3.91b falling due within a year, and liabilities of NT$7.45b due beyond that. Offsetting these obligations, it had cash of NT$2.07b as well as receivables valued at NT$1.38b due within 12 months. So its liabilities total NT$7.91b more than the combination of its cash and short-term receivables.

When you consider that this deficiency exceeds the company's NT$5.90b market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Weak interest cover of 2.4 times and a disturbingly high net debt to EBITDA ratio of 7.2 hit our confidence in Posiflex Technology like a one-two punch to the gut. The debt burden here is substantial. Even worse, Posiflex Technology saw its EBIT tank 35% over the last 12 months. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. 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 Posiflex Technology 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. So it's worth checking how much of that EBIT is backed by free cash flow. Over the most recent three years, Posiflex Technology recorded free cash flow worth 76% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

To be frank both Posiflex Technology's net debt to EBITDA and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. We're quite clear that we consider Posiflex Technology to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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. Take risks, for example - Posiflex Technology has 3 warning signs (and 1 which makes us a bit uncomfortable) we think you should know about.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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