David Iben put it well when he said, ‘Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.’ So it seems the smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess how risky a company is. We note that First Hi-tec Enterprise Co., Ltd. (GTSM:5439) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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.
What Is First Hi-tec Enterprise’s Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of September 2020 First Hi-tec Enterprise had NT$112.4m of debt, an increase on NT$49.4m, over one year. But it also has NT$340.6m in cash to offset that, meaning it has NT$228.1m net cash.
How Healthy Is First Hi-tec Enterprise’s Balance Sheet?
The latest balance sheet data shows that First Hi-tec Enterprise had liabilities of NT$674.0m due within a year, and liabilities of NT$59.5m falling due after that. Offsetting this, it had NT$340.6m in cash and NT$772.3m in receivables that were due within 12 months. So it actually has NT$379.4m more liquid assets than total liabilities.
This short term liquidity is a sign that First Hi-tec Enterprise could probably pay off its debt with ease, as its balance sheet is far from stretched. Succinctly put, First Hi-tec Enterprise boasts net cash, so it’s fair to say it does not have a heavy debt load!
Also good is that First Hi-tec Enterprise grew its EBIT at 18% over the last year, further increasing its ability to manage debt. There’s no doubt that we learn most about debt from the balance sheet. But you can’t view debt in total isolation; since First Hi-tec Enterprise 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.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While First Hi-tec Enterprise 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 most recent three years, First Hi-tec Enterprise recorded free cash flow worth 62% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
While we empathize with investors who find debt concerning, you should keep in mind that First Hi-tec Enterprise has net cash of NT$228.1m, as well as more liquid assets than liabilities. And we liked the look of last year’s 18% year-on-year EBIT growth. So we don’t think First Hi-tec Enterprise’s use of debt is risky. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet – far from it. Case in point: We’ve spotted 1 warning sign for First Hi-tec Enterprise you should be aware of.
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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