Neo Technical System (KOSDAQ:085910) Has A Pretty Healthy Balance Sheet

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. Importantly, Neo Technical System Co., Ltd. (KOSDAQ:085910) does carry debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Neo Technical System

What Is Neo Technical System's Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2020 Neo Technical System had ₩40.3b of debt, an increase on ₩24.8b, over one year. However, it does have ₩27.4b in cash offsetting this, leading to net debt of about ₩12.9b.

How Strong Is Neo Technical System's Balance Sheet?

The latest balance sheet data shows that Neo Technical System had liabilities of ₩42.7b due within a year, and liabilities of ₩12.9b falling due after that. Offsetting these obligations, it had cash of ₩27.4b as well as receivables valued at ₩13.2b due within 12 months. So it has liabilities totalling ₩15.1b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Neo Technical System has a market capitalization of ₩39.6b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

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.

Neo Technical System has net debt worth 1.8 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 4.2 times the interest expense. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. If Neo Technical System can keep growing EBIT at last year's rate of 13% over the last year, then it will find its debt load easier to manage. When analysing debt levels, the balance sheet is the obvious place to start. But it is Neo Technical System'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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Neo Technical System generated free cash flow amounting to a very robust 84% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Our View

Happily, Neo Technical System's impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. But, on a more sombre note, we are a little concerned by its interest cover. All these things considered, it appears that Neo Technical System can comfortably handle its current debt levels. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Consider for instance, the ever-present spectre of investment risk. We've identified 5 warning signs with Neo Technical System (at least 1 which is significant) , and understanding them should be part of your investment process.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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