Warren Buffett famously said, ‘Volatility is far from synonymous with risk.’ When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Perfect Medical Industry Co., Ltd. (GTSM:6543) does use debt in its business. But the real question is whether this debt is making the company risky.
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. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. 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. The first step when considering a company’s debt levels is to consider its cash and debt together.
What Is Perfect Medical Industry’s Debt?
The image below, which you can click on for greater detail, shows that at June 2020 Perfect Medical Industry had debt of NT$154.4m, up from NT$76.4m in one year. However, it also had NT$146.9m in cash, and so its net debt is NT$7.51m.
How Healthy Is Perfect Medical Industry’s Balance Sheet?
According to the last reported balance sheet, Perfect Medical Industry had liabilities of NT$276.7m due within 12 months, and liabilities of NT$36.4m due beyond 12 months. Offsetting these obligations, it had cash of NT$146.9m as well as receivables valued at NT$101.6m due within 12 months. So it has liabilities totalling NT$64.6m more than its cash and near-term receivables, combined.
Given Perfect Medical Industry has a market capitalization of NT$1.21b, it’s hard to believe these liabilities pose much threat. Having said that, it’s clear that we should continue to monitor its balance sheet, lest it change for the worse. Carrying virtually no net debt, Perfect Medical Industry has a very light debt load indeed.
We measure a company’s debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
With debt at a measly 0.074 times EBITDA and EBIT covering interest a whopping 79.0 times, it’s clear that Perfect Medical Industry is not a desperate borrower. Indeed relative to its earnings its debt load seems light as a feather. In addition to that, we’re happy to report that Perfect Medical Industry has boosted its EBIT by 65%, thus reducing the spectre of future debt repayments. There’s no doubt that we learn most about debt from the balance sheet. But you can’t view debt in total isolation; since Perfect Medical Industry 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, 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. In the last three years, Perfect Medical Industry’s free cash flow amounted to 35% of its EBIT, less than we’d expect. That’s not great, when it comes to paying down debt.
The good news is that Perfect Medical Industry’s demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But truth be told we feel its conversion of EBIT to free cash flow does undermine this impression a bit. It’s also worth noting that Perfect Medical Industry is in the Medical Equipment industry, which is often considered to be quite defensive. Looking at the bigger picture, we think Perfect Medical Industry’s use of debt seems quite reasonable and we’re not concerned about it. While debt does bring risk, when used wisely it can also bring a higher return on equity. 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. Consider for instance, the ever-present spectre of investment risk. We’ve identified 3 warning signs with Perfect Medical Industry , and understanding them should be part of your investment process.
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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