Here's Why Ko Yo Chemical (Group) (HKG:827) Is Weighed Down By Its Debt Load

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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. As with many other companies Ko Yo Chemical (Group) Limited (HKG:827) makes use of debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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 Ko Yo Chemical (Group)

What Is Ko Yo Chemical (Group)'s Debt?

The image below, which you can click on for greater detail, shows that at June 2024 Ko Yo Chemical (Group) had debt of CN¥3.25b, up from CN¥2.84b in one year. Net debt is about the same, since the it doesn't have much cash.

How Strong Is Ko Yo Chemical (Group)'s Balance Sheet?

We can see from the most recent balance sheet that Ko Yo Chemical (Group) had liabilities of CN¥4.21b falling due within a year, and liabilities of CN¥1.02b due beyond that. Offsetting these obligations, it had cash of CN¥52.8m as well as receivables valued at CN¥152.1m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥5.03b.

This deficit casts a shadow over the CN¥324.9m company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Ko Yo Chemical (Group) would likely require a major re-capitalisation if it had to pay its creditors today.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Weak interest cover of 0.47 times and a disturbingly high net debt to EBITDA ratio of 12.0 hit our confidence in Ko Yo Chemical (Group) like a one-two punch to the gut. The debt burden here is substantial. Worse, Ko Yo Chemical (Group)'s EBIT was down 47% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. There's no doubt that we learn most about debt from the balance sheet. But it is Ko Yo Chemical (Group)'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Ko Yo Chemical (Group) 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, Ko Yo Chemical (Group)'s EBIT growth rate left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. And even its interest cover fails to inspire much confidence. It looks to us like Ko Yo Chemical (Group) carries a significant balance sheet burden. If you play with fire you risk getting burnt, so we'd probably give this stock a wide berth. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 2 warning signs for Ko Yo Chemical (Group) you should be aware of.

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.