These 4 Measures Indicate That Dayou PlusLtd (KRX:000300) Is Using Debt Extensively

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.' 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. Importantly, Dayou Plus Co.,Ltd (KRX:000300) does carry debt. But the more important question is: how much risk is that debt creating?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Dayou PlusLtd

What Is Dayou PlusLtd's Debt?

The image below, which you can click on for greater detail, shows that at September 2020 Dayou PlusLtd had debt of ₩168.3b, up from ₩125.3b in one year. However, because it has a cash reserve of ₩38.7b, its net debt is less, at about ₩129.6b.

A Look At Dayou PlusLtd's Liabilities

We can see from the most recent balance sheet that Dayou PlusLtd had liabilities of ₩267.9b falling due within a year, and liabilities of ₩70.5b due beyond that. Offsetting this, it had ₩38.7b in cash and ₩83.4b in receivables that were due within 12 months. So its liabilities total ₩216.2b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the ₩91.2b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. At the end of the day, Dayou PlusLtd would probably need a major re-capitalization if its creditors were to demand repayment.

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

Dayou PlusLtd's net debt of 2.5 times EBITDA suggests graceful use of debt. And the alluring interest cover (EBIT of 9.5 times interest expense) certainly does not do anything to dispel this impression. Importantly, Dayou PlusLtd grew its EBIT by 52% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is Dayou PlusLtd'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 company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Dayou PlusLtd's free cash flow amounted to 37% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

Dayou PlusLtd's level of total liabilities and conversion of EBIT to free cash flow definitely weigh on it, in our esteem. But the good news is it seems to be able to grow its EBIT with ease. When we consider all the factors discussed, it seems to us that Dayou PlusLtd is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. For example, we've discovered 2 warning signs for Dayou PlusLtd that you should be aware of before investing here.

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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