Is AeroSpace Technology of Korea (KOSDAQ:067390) Using Too Much 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.' 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 AeroSpace Technology of Korea Inc. (KOSDAQ:067390) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for AeroSpace Technology of Korea

What Is AeroSpace Technology of Korea's Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2020 AeroSpace Technology of Korea had ₩280.6b of debt, an increase on ₩195.8b, over one year. On the flip side, it has ₩11.4b in cash leading to net debt of about ₩269.2b.

How Strong Is AeroSpace Technology of Korea's Balance Sheet?

We can see from the most recent balance sheet that AeroSpace Technology of Korea had liabilities of ₩172.0b falling due within a year, and liabilities of ₩202.7b due beyond that. Offsetting this, it had ₩11.4b in cash and ₩31.4b in receivables that were due within 12 months. So it has liabilities totalling ₩332.0b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the ₩118.8b 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. At the end of the day, AeroSpace Technology of Korea would probably need a major re-capitalization if its creditors were to demand repayment.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Weak interest cover of 0.50 times and a disturbingly high net debt to EBITDA ratio of 12.9 hit our confidence in AeroSpace Technology of Korea like a one-two punch to the gut. The debt burden here is substantial. Worse, AeroSpace Technology of Korea's EBIT was down 49% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. 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 AeroSpace Technology of Korea 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.

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. Over the last three years, AeroSpace Technology of Korea 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

On the face of it, AeroSpace Technology of Korea's EBIT growth rate left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. And even its interest cover fails to inspire much confidence. It looks to us like AeroSpace Technology of Korea carries a significant balance sheet burden. If you play with fire you risk getting burnt, so we'd probably give this stock a wide berth. 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. Take risks, for example - AeroSpace Technology of Korea has 2 warning signs we think 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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