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. We can see that Hwashin Precision Engineering Co., Ltd. (KOSDAQ:126640) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
Generally speaking, debt only becomes a real problem when a company can’t easily pay it off, either by raising capital or with its own cash flow. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Hwashin Precision Engineering’s Debt?
The image below, which you can click on for greater detail, shows that at September 2019 Hwashin Precision Engineering had debt of ₩20.0b, up from none in one year. But on the other hand it also has ₩33.2b in cash, leading to a ₩13.2b net cash position.
How Strong Is Hwashin Precision Engineering’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Hwashin Precision Engineering had liabilities of ₩36.8b due within 12 months and liabilities of ₩19.1b due beyond that. Offsetting these obligations, it had cash of ₩33.2b as well as receivables valued at ₩30.4b due within 12 months. So it actually has ₩7.82b more liquid assets than total liabilities.
This excess liquidity suggests that Hwashin Precision Engineering is taking a careful approach to debt. Because it has plenty of assets, it is unlikely to have trouble with its lenders. Simply put, the fact that Hwashin Precision Engineering has more cash than debt is arguably a good indication that it can manage its debt safely.
Even more impressive was the fact that Hwashin Precision Engineering grew its EBIT by 401% over twelve months. That boost will make it even easier to pay down debt going forward. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Hwashin Precision Engineering’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.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. Hwashin Precision Engineering 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, Hwashin Precision Engineering recorded free cash flow worth 61% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
While we empathize with investors who find debt concerning, you should keep in mind that Hwashin Precision Engineering has net cash of ₩13.2b, as well as more liquid assets than liabilities. And we liked the look of last year’s 401% year-on-year EBIT growth. So we don’t think Hwashin Precision Engineering’s use of debt is risky. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet – far from it. Case in point: We’ve spotted 2 warning signs for Hwashin Precision Engineering you should be aware of, and 1 of them can’t be ignored.
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.
If you spot an error that warrants correction, please contact the editor at email@example.com. 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. Simply Wall St has no position in the stocks mentioned.
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