These 4 Measures Indicate That Korea Fuel-Tech (KOSDAQ:123410) Is Using Debt In A Risky Way

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Korea Fuel-Tech Corporation (KOSDAQ:123410) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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.

Check out our latest analysis for Korea Fuel-Tech

What Is Korea Fuel-Tech's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Korea Fuel-Tech had ₩124.4b of debt, an increase on ₩101.8b, over one year. On the flip side, it has ₩36.5b in cash leading to net debt of about ₩88.0b.

How Strong Is Korea Fuel-Tech's Balance Sheet?

We can see from the most recent balance sheet that Korea Fuel-Tech had liabilities of ₩165.8b falling due within a year, and liabilities of ₩72.1b due beyond that. Offsetting these obligations, it had cash of ₩36.5b as well as receivables valued at ₩67.7b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₩133.7b.

When you consider that this deficiency exceeds the company's ₩99.3b market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

While we wouldn't worry about Korea Fuel-Tech's net debt to EBITDA ratio of 3.4, we think its super-low interest cover of 0.77 times is a sign of high leverage. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. Even worse, Korea Fuel-Tech saw its EBIT tank 70% over the last 12 months. 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. When analysing debt levels, the balance sheet is the obvious place to start. But it is Korea Fuel-Tech's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

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. During the last three years, Korea Fuel-Tech burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

To be frank both Korea Fuel-Tech's conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. And even its level of total liabilities fails to inspire much confidence. Considering all the factors previously mentioned, we think that Korea Fuel-Tech really is carrying too much debt. To us, that makes the stock rather risky, like walking through a dog park with your eyes closed. But some investors may feel differently. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 5 warning signs for Korea Fuel-Tech you should be aware of, and 2 of them shouldn't be ignored.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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This article by Simply Wall St is general in nature. 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.
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