Here's Why Daedong Gear (KOSDAQ:008830) Has A Meaningful Debt Burden

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.' 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 Daedong Gear Co., Ltd. (KOSDAQ:008830) makes use of debt. But is this debt a concern to shareholders?

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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Daedong Gear

What Is Daedong Gear's Net Debt?

The image below, which you can click on for greater detail, shows that Daedong Gear had debt of ₩79.7b at the end of December 2023, a reduction from ₩83.3b over a year. However, it does have ₩1.72b in cash offsetting this, leading to net debt of about ₩78.0b.

How Strong Is Daedong Gear's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Daedong Gear had liabilities of ₩126.9b due within 12 months and liabilities of ₩32.3b due beyond that. On the other hand, it had cash of ₩1.72b and ₩46.6b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₩110.8b.

This deficit is considerable relative to its market capitalization of ₩119.7b, so it does suggest shareholders should keep an eye on Daedong Gear's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Weak interest cover of 2.0 times and a disturbingly high net debt to EBITDA ratio of 5.2 hit our confidence in Daedong Gear like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. The good news is that Daedong Gear improved its EBIT by 6.6% over the last twelve months, thus gradually reducing its debt levels relative to its earnings. When analysing debt levels, the balance sheet is the obvious place to start. But it is Daedong Gear'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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Daedong Gear recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

On the face of it, Daedong Gear's interest cover left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at growing its EBIT; that's encouraging. Overall, it seems to us that Daedong Gear's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 4 warning signs for Daedong Gear (2 make us uncomfortable) you should be aware of.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.