Does Formetal (KOSDAQ:119500) Have A Healthy Balance Sheet?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. We can see that Formetal Co., Ltd. (KOSDAQ:119500) does use debt in its business. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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, 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.

View our latest analysis for Formetal

What Is Formetal's Net Debt?

The image below, which you can click on for greater detail, shows that Formetal had debt of ₩7.48b at the end of September 2020, a reduction from ₩8.92b over a year. However, because it has a cash reserve of ₩3.02b, its net debt is less, at about ₩4.46b.

How Healthy Is Formetal's Balance Sheet?

We can see from the most recent balance sheet that Formetal had liabilities of ₩13.4b falling due within a year, and liabilities of ₩3.98b due beyond that. On the other hand, it had cash of ₩3.02b and ₩8.97b worth of receivables due within a year. So its liabilities total ₩5.41b more than the combination of its cash and short-term receivables.

Of course, Formetal has a market capitalization of ₩51.1b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Formetal's net debt is only 1.1 times its EBITDA. And its EBIT easily covers its interest expense, being 13.5 times the size. So we're pretty relaxed about its super-conservative use of debt. But the bad news is that Formetal has seen its EBIT plunge 12% in the last twelve months. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Formetal'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Formetal reported free cash flow worth 2.1% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

Formetal's conversion of EBIT to free cash flow and EBIT growth rate definitely weigh on it, in our esteem. But its interest cover tells a very different story, and suggests some resilience. Looking at all the angles mentioned above, it does seem to us that Formetal is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. 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. To that end, you should be aware of the 1 warning sign we've spotted with Formetal .

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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