Here's Why Formetal (KOSDAQ:119500) Has A Meaningful Debt Burden

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. We can see that Formetal Co., Ltd. (KOSDAQ:119500) does use debt in its business. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Formetal

What Is Formetal's Debt?

The chart below, which you can click on for greater detail, shows that Formetal had ₩8.91b in debt in June 2020; about the same as the year before. However, it also had ₩2.55b in cash, and so its net debt is ₩6.36b.

How Healthy Is Formetal's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Formetal had liabilities of ₩10.3b due within 12 months and liabilities of ₩7.30b due beyond that. Offsetting these obligations, it had cash of ₩2.55b as well as receivables valued at ₩9.11b due within 12 months. So it has liabilities totalling ₩5.90b more than its cash and near-term receivables, combined.

Of course, Formetal has a market capitalization of ₩43.0b, 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 1.5. And its EBIT easily covers its interest expense, being 12.8 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. But the other side of the story is that Formetal saw its EBIT decline by 3.4% over the last year. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Formetal will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs 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, Formetal saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

Formetal's conversion of EBIT to free cash flow and EBIT growth rate definitely weigh on it, in our esteem. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. We think that Formetal's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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 1 warning sign for Formetal that you should be aware of.

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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This article by Simply Wall St is general in nature. 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.
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