Does EDOM Technology (TWSE:3048) Have A Healthy Balance Sheet?

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.' 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 can see that EDOM Technology Co., Ltd. (TWSE:3048) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for EDOM Technology

What Is EDOM Technology's Net Debt?

The image below, which you can click on for greater detail, shows that EDOM Technology had debt of NT$8.94b at the end of March 2024, a reduction from NT$9.45b over a year. However, it also had NT$1.78b in cash, and so its net debt is NT$7.16b.

How Healthy Is EDOM Technology's Balance Sheet?

We can see from the most recent balance sheet that EDOM Technology had liabilities of NT$21.0b falling due within a year, and liabilities of NT$1.17b due beyond that. On the other hand, it had cash of NT$1.78b and NT$9.68b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$10.8b.

Given this deficit is actually higher than the company's market capitalization of NT$8.20b, we think shareholders really should watch EDOM Technology's debt levels, like a parent watching their child ride a bike for the first time. 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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

While we wouldn't worry about EDOM Technology's net debt to EBITDA ratio of 4.7, we think its super-low interest cover of 0.94 times is a sign of high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Investors should also be troubled by the fact that EDOM Technology saw its EBIT drop by 16% over the last twelve months. If things keep going like that, handling the debt will about as easy as bundling an angry house cat into its travel box. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since EDOM Technology will need earnings to service that debt. 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, EDOM Technology recorded free cash flow worth 57% 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 EDOM Technology's EBIT growth rate and its track record of covering its interest expense with 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. Overall, it seems to us that EDOM Technology's balance sheet is really quite a risk to the business. 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. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 6 warning signs for EDOM Technology you should be aware of, and 2 of them are a bit unpleasant.

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. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.