Here’s why Impro Precision Industries (HKG:1286) can manage debt responsibly

Warren Buffett said: “Volatility is far from synonymous with risk. So it may be obvious that you need to take debt into account when thinking about the risk of a given stock, because too much debt can sink a business. Above all, Improv Precision Industries Limited (HKG:1286) is in debt. But should shareholders worry about its use of debt?

What risk does debt carry?

Generally speaking, debt only becomes a real problem when a company cannot easily repay it, either by raising capital or with its own cash flow. Ultimately, if the company cannot meet its legal debt repayment obligations, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is when a company has to dilute shareholders at a cheap share price just to keep debt under control. By replacing dilution, however, debt can be a great tool for companies 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.

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What is Impro Precision Industries’ net debt?

You can click on the graph below for historical numbers, but it shows that in June 2022, Impro Precision Industries had HK$1.86 billion in debt, an increase of HK$920.8 million, over a year. However, he has HK$751.7 million in cash to offset this, resulting in a net debt of around HK$1.11 billion.

SEHK: 1286 Historical Debt to Equity November 9, 2022

How healthy is Impro Precision Industries’ balance sheet?

According to the last published balance sheet, Impro Precision Industries had liabilities of HK$1.78 billion due within 12 months and liabilities of HK$1.23 billion due beyond 12 months. In return, he had HK$751.7 million in cash and HK$1.24 billion in debt due within 12 months. It therefore has liabilities totaling HK$1.01 billion more than its cash and short-term receivables, combined.

While that might sound like a lot, it’s not that bad since Impro Precision Industries has a market capitalization of HK$4.26 billion, so it could probably bolster its balance sheet by raising capital if needed. But it is clear that it is essential to examine closely whether it can manage its debt without dilution.

We use two main ratios to inform us about debt to earnings levels. The first is net debt divided by earnings before interest, taxes, depreciation and amortization (EBITDA), while the second is how often its earnings before interest and taxes (EBIT) covers its interest expense (or its interests, for short). The advantage of this approach is that we consider both the absolute amount of debt (with net debt to EBITDA) and the actual interest expense associated with that debt (with its interest coverage ratio ).

Impro Precision Industries’ net debt is only 1.1 times its EBITDA. And its EBIT easily covers its interest charges, being 20.0 times greater. So we’re pretty relaxed about his super-conservative use of debt. On top of that, Impro Precision Industries has grown its EBIT by 31% over the last twelve months, and this growth will make it easier to manage its debt. When analyzing debt levels, the balance sheet is the obvious starting point. But it is future earnings, more than anything, that will determine Impro Precision Industries’ ability to maintain a healthy balance sheet in the future. So if you are focused on the future, you can check out this free report showing analyst earnings forecast.

Finally, a company can only repay its debts with cold hard cash, not with book profits. We therefore always check how much of this EBIT is converted into free cash flow. Over the past three years, Impro Precision Industries has created free cash flow of 11% of its EBIT, an uninspiring performance. For us, such a low cash conversion creates a bit of paranoia about the ability to extinguish the debt.

Our point of view

Fortunately, Impro Precision Industries’ impressive interest coverage means it has the upper hand on its debt. But we have to admit that we see that converting it from EBIT to free cash flow has the opposite effect. All told, it looks like Impro Precision Industries can comfortably manage its current level of debt. On the plus side, this leverage can increase shareholder returns, but the potential downside is more risk of loss, so it’s worth keeping an eye on the balance sheet. There is no doubt that we learn the most about debt from the balance sheet. However, not all investment risks reside on the balance sheet, far from it. To this end, you should be aware of the 1 warning sign we spotted with Impro Precision Industries.

In the end, it’s often best to focus on companies that aren’t in debt. You can access our special list of these companies (all with a track record of earnings growth). It’s free.

Valuation is complex, but we help make it simple.

Find out if Impro Precision Industries is potentially overvalued or undervalued by viewing our full analysis, which includes fair value estimates, risks and warnings, dividends, insider trading and financial health.

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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.

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