Is Cosmo Chemical (KRX:005420) Using Too Much Debt?

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. As with many other companies Cosmo Chemical Co., Ltd. (KRX:005420) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Cosmo Chemical

What Is Cosmo Chemical's Net Debt?

As you can see below, Cosmo Chemical had ₩238.6b of debt, at December 2023, which is about the same as the year before. You can click the chart for greater detail. However, it does have ₩70.3b in cash offsetting this, leading to net debt of about ₩168.3b.

How Strong Is Cosmo Chemical's Balance Sheet?

We can see from the most recent balance sheet that Cosmo Chemical had liabilities of ₩323.1b falling due within a year, and liabilities of ₩123.4b due beyond that. Offsetting these obligations, it had cash of ₩70.3b as well as receivables valued at ₩93.3b due within 12 months. So it has liabilities totalling ₩283.0b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Cosmo Chemical has a market capitalization of ₩1.17t, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

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.

Cosmo Chemical shareholders face the double whammy of a high net debt to EBITDA ratio (6.1), and fairly weak interest coverage, since EBIT is just 0.38 times the interest expense. This means we'd consider it to have a heavy debt load. Worse, Cosmo Chemical's EBIT was down 93% over the last year. 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 you can't view debt in total isolation; since Cosmo Chemical 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Cosmo Chemical saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

On the face of it, Cosmo Chemical's conversion of EBIT to free cash flow left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But at least its level of total liabilities is not so bad. Overall, it seems to us that Cosmo Chemical'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. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Cosmo Chemical you should know about.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.