Does Hwacheon Machine Tool (KRX:000850) Have A Healthy Balance Sheet?

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Hwacheon Machine Tool Co. Ltd (KRX:000850) does use debt in its business. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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.

Check out our latest analysis for Hwacheon Machine Tool

What Is Hwacheon Machine Tool's Debt?

The image below, which you can click on for greater detail, shows that at December 2020 Hwacheon Machine Tool had debt of ₩20.6b, up from ₩14.7b in one year. But it also has ₩66.3b in cash to offset that, meaning it has ₩45.7b net cash.

How Strong Is Hwacheon Machine Tool's Balance Sheet?

We can see from the most recent balance sheet that Hwacheon Machine Tool had liabilities of ₩46.4b falling due within a year, and liabilities of ₩35.8b due beyond that. Offsetting this, it had ₩66.3b in cash and ₩27.1b in receivables that were due within 12 months. So it actually has ₩11.2b more liquid assets than total liabilities.

This short term liquidity is a sign that Hwacheon Machine Tool could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Hwacheon Machine Tool has more cash than debt is arguably a good indication that it can manage its debt safely.

In fact Hwacheon Machine Tool's saving grace is its low debt levels, because its EBIT has tanked 79% in the last twelve months. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. There's no doubt that we learn most about debt from the balance sheet. But it is Hwacheon Machine Tool'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. Hwacheon Machine Tool may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the most recent three years, Hwacheon Machine Tool recorded free cash flow worth 56% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Summing up

While it is always sensible to investigate a company's debt, in this case Hwacheon Machine Tool has ₩45.7b in net cash and a decent-looking balance sheet. So we don't have any problem with Hwacheon Machine Tool's use of debt. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 3 warning signs for Hwacheon Machine Tool (1 is significant!) that you should be aware of before investing here.

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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