SGC eTEC E&C (KOSDAQ:016250) Takes On Some Risk With Its Use Of Debt

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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that SGC eTEC E&C Co., Ltd. (KOSDAQ:016250) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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 think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for SGC eTEC E&C

What Is SGC eTEC E&C's Net Debt?

The image below, which you can click on for greater detail, shows that SGC eTEC E&C had debt of ₩58.3b at the end of September 2020, a reduction from ₩941.6b over a year. However, it does have ₩118.5b in cash offsetting this, leading to net cash of ₩60.1b.

A Look At SGC eTEC E&C's Liabilities

Zooming in on the latest balance sheet data, we can see that SGC eTEC E&C had liabilities of ₩1.05t due within 12 months and liabilities of ₩869.6b due beyond that. On the other hand, it had cash of ₩118.5b and ₩238.5b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₩1.57t.

The deficiency here weighs heavily on the ₩172.2b 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'd watch its balance sheet closely, without a doubt. After all, SGC eTEC E&C would likely require a major re-capitalisation if it had to pay its creditors today. SGC eTEC E&C boasts net cash, so it's fair to say it does not have a heavy debt load, even if it does have very significant liabilities, in total.

Pleasingly, SGC eTEC E&C is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 145% gain in the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since SGC eTEC E&C 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. SGC eTEC E&C 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, SGC eTEC E&C recorded free cash flow worth 60% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Summing up

While SGC eTEC E&C does have more liabilities than liquid assets, it also has net cash of ₩60.1b. And it impressed us with its EBIT growth of 145% over the last year. So although we see some areas for improvement, we're not too worried about SGC eTEC E&C's balance sheet. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 2 warning signs for SGC eTEC E&C (1 makes us a bit uncomfortable) you should be aware of.

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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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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