Clean & Science (KOSDAQ:045520) Seems To Use Debt Quite Sensibly

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. As with many other companies Clean & Science Co., Ltd. (KOSDAQ:045520) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Clean & Science

What Is Clean & Science's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2020 Clean & Science had debt of ₩46.7b, up from ₩32.7b in one year. However, because it has a cash reserve of ₩19.0b, its net debt is less, at about ₩27.7b.

A Look At Clean & Science's Liabilities

According to the last reported balance sheet, Clean & Science had liabilities of ₩40.9b due within 12 months, and liabilities of ₩33.9b due beyond 12 months. Offsetting these obligations, it had cash of ₩19.0b as well as receivables valued at ₩21.0b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₩34.8b.

Clean & Science has a market capitalization of ₩173.8b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Clean & Science has a low net debt to EBITDA ratio of only 1.1. And its EBIT easily covers its interest expense, being 28.6 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. In addition to that, we're happy to report that Clean & Science has boosted its EBIT by 60%, thus reducing the spectre of future debt repayments. 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 Clean & Science will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Clean & Science saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Based on what we've seen Clean & Science is not finding it easy, given its conversion of EBIT to free cash flow, but the other factors we considered give us cause to be optimistic. In particular, we are dazzled with its interest cover. Considering this range of data points, we think Clean & Science is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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. For example, we've discovered 2 warning signs for Clean & Science (1 is potentially serious!) 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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