Stock Analysis

Here's Why Oriental Precision & EngineeringLtd (KOSDAQ:014940) Can Manage Its Debt Responsibly

KOSDAQ:A014940
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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 Oriental Precision & Engineering Co.,Ltd. (KOSDAQ:014940) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Oriental Precision & EngineeringLtd

What Is Oriental Precision & EngineeringLtd's Net Debt?

As you can see below, Oriental Precision & EngineeringLtd had ₩63.7b of debt at September 2020, down from ₩72.9b a year prior. On the flip side, it has ₩18.8b in cash leading to net debt of about ₩44.9b.

debt-equity-history-analysis
KOSDAQ:A014940 Debt to Equity History January 27th 2021

How Strong Is Oriental Precision & EngineeringLtd's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Oriental Precision & EngineeringLtd had liabilities of ₩94.5b due within 12 months and liabilities of ₩22.3b due beyond that. Offsetting these obligations, it had cash of ₩18.8b as well as receivables valued at ₩574.0m due within 12 months. So its liabilities total ₩97.4b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of ₩141.7b, so it does suggest shareholders should keep an eye on Oriental Precision & EngineeringLtd's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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.

Oriental Precision & EngineeringLtd's net debt of 1.9 times EBITDA suggests graceful use of debt. And the fact that its trailing twelve months of EBIT was 7.8 times its interest expenses harmonizes with that theme. Notably, Oriental Precision & EngineeringLtd's EBIT launched higher than Elon Musk, gaining a whopping 1,119% on last year. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Oriental Precision & EngineeringLtd will need earnings to service that debt. 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 we always check how much of that EBIT is translated into free cash flow. During the last two years, Oriental Precision & EngineeringLtd generated free cash flow amounting to a very robust 80% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Our View

The good news is that Oriental Precision & EngineeringLtd's demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. But, on a more sombre note, we are a little concerned by its level of total liabilities. When we consider the range of factors above, it looks like Oriental Precision & EngineeringLtd is pretty sensible with its use of debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 2 warning signs for Oriental Precision & EngineeringLtd 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. 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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