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.' 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. We can see that Daewon Sanup Co., Ltd (KOSDAQ:005710) does use debt in its business. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
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. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Daewon Sanup's Debt?
You can click the graphic below for the historical numbers, but it shows that Daewon Sanup had ₩25.7b of debt in September 2020, down from ₩30.3b, one year before. However, its balance sheet shows it holds ₩184.7b in cash, so it actually has ₩159.0b net cash.
A Look At Daewon Sanup's Liabilities
Zooming in on the latest balance sheet data, we can see that Daewon Sanup had liabilities of ₩175.8b due within 12 months and liabilities of ₩36.7b due beyond that. On the other hand, it had cash of ₩184.7b and ₩146.7b worth of receivables due within a year. So it actually has ₩118.9b more liquid assets than total liabilities.
This surplus liquidity suggests that Daewon Sanup's balance sheet could take a hit just as well as Homer Simpson's head can take a punch. With this in mind one could posit that its balance sheet means the company is able to handle some adversity. Simply put, the fact that Daewon Sanup has more cash than debt is arguably a good indication that it can manage its debt safely.
The modesty of its debt load may become crucial for Daewon Sanup if management cannot prevent a repeat of the 58% cut to EBIT over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Daewon Sanup'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. Daewon Sanup may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the most recent three years, Daewon Sanup recorded free cash flow worth 65% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
While it is always sensible to investigate a company's debt, in this case Daewon Sanup has ₩159.0b in net cash and a decent-looking balance sheet. So we don't think Daewon Sanup's use of debt is risky. 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. To that end, you should be aware of the 2 warning signs we've spotted with Daewon Sanup .
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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