Formetal (KOSDAQ:119500) Could Easily Take On More Debt

Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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 Formetal Co., Ltd. (KOSDAQ:119500) does have debt on its balance sheet. But is this debt a concern to shareholders?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. 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?

As you can see below, Formetal had ₩5.03b of debt at March 2024, down from ₩7.24b a year prior. However, it does have ₩1.90b in cash offsetting this, leading to net debt of about ₩3.13b.

How Healthy Is Formetal's Balance Sheet?

According to the last reported balance sheet, Formetal had liabilities of ₩14.5b due within 12 months, and liabilities of ₩1.79b due beyond 12 months. Offsetting this, it had ₩1.90b in cash and ₩11.5b in receivables that were due within 12 months. So it has liabilities totalling ₩2.91b more than its cash and near-term receivables, combined.

Of course, Formetal has a market capitalization of ₩34.8b, 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Formetal has a low net debt to EBITDA ratio of only 0.71. And its EBIT covers its interest expense a whopping 10.5 times over. So we're pretty relaxed about its super-conservative use of debt. In addition to that, we're happy to report that Formetal has boosted its EBIT by 32%, thus reducing the spectre of future debt repayments. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Formetal 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Formetal recorded free cash flow worth a fulsome 86% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Our View

The good news is that Formetal's demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. And the good news does not stop there, as its EBIT growth rate also supports that impression! Overall, we don't think Formetal is taking any bad risks, as its debt load seems modest. So we're not worried about the use of a little leverage on 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. For instance, we've identified 3 warning signs for Formetal (1 is a bit concerning) you should be aware of.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.