K&S (ASX:KSC) Has A Somewhat Strained 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 K&S Corporation Limited (ASX:KSC) does use debt in its business. But is this debt a concern to shareholders?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for K&S

What Is K&S's Debt?

You can click the graphic below for the historical numbers, but it shows that K&S had AU$49.0m of debt in June 2021, down from AU$86.8m, one year before. However, it does have AU$22.5m in cash offsetting this, leading to net debt of about AU$26.6m.

How Healthy Is K&S' Balance Sheet?

We can see from the most recent balance sheet that K&S had liabilities of AU$121.9m falling due within a year, and liabilities of AU$135.2m due beyond that. On the other hand, it had cash of AU$22.5m and AU$94.2m worth of receivables due within a year. So it has liabilities totalling AU$140.5m more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of AU$231.8m. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

While K&S's low debt to EBITDA ratio of 0.44 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 4.9 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. Shareholders should be aware that K&S's EBIT was down 28% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. The balance sheet is clearly the area to focus on when you are analysing debt. But it is K&S's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Happily for any shareholders, K&S actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

We feel some trepidation about K&S's difficulty EBIT growth rate, but we've got positives to focus on, too. For example, its conversion of EBIT to free cash flow and net debt to EBITDA give us some confidence in its ability to manage its debt. We think that K&S's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example - K&S has 1 warning sign we think you should be aware of.

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.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.