HANSHIN Engineering & Construction (KRX:004960) Has A Pretty 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 HANSHIN Engineering & Construction Co., Ltd. (KRX:004960) does use debt in its business. But the real question is whether this debt is making the company risky.

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. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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 HANSHIN Engineering & Construction

What Is HANSHIN Engineering & Construction's Net Debt?

The image below, which you can click on for greater detail, shows that HANSHIN Engineering & Construction had debt of ₩515.9b at the end of September 2020, a reduction from ₩570.1b over a year. However, because it has a cash reserve of ₩485.2b, its net debt is less, at about ₩30.7b.

A Look At HANSHIN Engineering & Construction's Liabilities

Zooming in on the latest balance sheet data, we can see that HANSHIN Engineering & Construction had liabilities of ₩773.3b due within 12 months and liabilities of ₩324.2b due beyond that. Offsetting these obligations, it had cash of ₩485.2b as well as receivables valued at ₩304.6b due within 12 months. So it has liabilities totalling ₩307.7b more than its cash and near-term receivables, combined.

When you consider that this deficiency exceeds the company's ₩242.4b market capitalization, you might well be inclined to review the balance sheet intently. 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.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

HANSHIN Engineering & Construction has a low net debt to EBITDA ratio of only 0.20. And its EBIT covers its interest expense a whopping 11.4 times over. So we're pretty relaxed about its super-conservative use of debt. Another good sign is that HANSHIN Engineering & Construction has been able to increase its EBIT by 20% in twelve months, making it easier to pay down debt. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since HANSHIN Engineering & Construction 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. During the last three years, HANSHIN Engineering & Construction produced sturdy free cash flow equating to 64% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Both HANSHIN Engineering & Construction's ability to to cover its interest expense with its EBIT and its net debt to EBITDA gave us comfort that it can handle its debt. But truth be told its level of total liabilities had us nibbling our nails. Considering this range of data points, we think HANSHIN Engineering & Construction is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. 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 3 warning signs for HANSHIN Engineering & Construction that you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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