Is Tong Yang Moolsan (KRX:002900) Using Too Much Debt?

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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Tong Yang Moolsan Co., Ltd. (KRX:002900) does carry debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Tong Yang Moolsan

What Is Tong Yang Moolsan's Net Debt?

As you can see below, Tong Yang Moolsan had ₩240.2b of debt, at September 2020, which is about the same as the year before. You can click the chart for greater detail. However, it also had ₩98.3b in cash, and so its net debt is ₩141.9b.

How Strong Is Tong Yang Moolsan's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Tong Yang Moolsan had liabilities of ₩413.6b due within 12 months and liabilities of ₩101.7b due beyond that. Offsetting these obligations, it had cash of ₩98.3b as well as receivables valued at ₩140.9b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₩276.1b.

Given this deficit is actually higher than the company's market capitalization of ₩213.6b, we think shareholders really should watch Tong Yang Moolsan's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Tong Yang Moolsan has a debt to EBITDA ratio of 3.0 and its EBIT covered its interest expense 2.7 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. One redeeming factor for Tong Yang Moolsan is that it turned last year's EBIT loss into a gain of ₩30b, over the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Tong Yang Moolsan can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, Tong Yang Moolsan actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

Neither Tong Yang Moolsan's ability to handle its total liabilities nor its interest cover gave us confidence in its ability to take on more debt. But the good news is it seems to be able to convert EBIT to free cash flow with ease. Taking the abovementioned factors together we do think Tong Yang Moolsan's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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 instance, we've identified 4 warning signs for Tong Yang Moolsan (1 is potentially serious) you should be aware of.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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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