HANSHIN Engineering & Construction (KRX:004960) Takes On Some Risk With Its Use Of 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.' 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. We note that HANSHIN Engineering & Construction Co., Ltd. (KRX:004960) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, 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. 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 chart below, which you can click on for greater detail, shows that HANSHIN Engineering & Construction had ₩569.6b in debt in December 2020; about the same as the year before. However, it also had ₩411.2b in cash, and so its net debt is ₩158.4b.

How Healthy Is HANSHIN Engineering & Construction's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that HANSHIN Engineering & Construction had liabilities of ₩782.5b due within 12 months and liabilities of ₩331.0b due beyond that. On the other hand, it had cash of ₩411.2b and ₩300.4b worth of receivables due within a year. So its liabilities total ₩401.9b more than the combination of its cash and short-term receivables.

When you consider that this deficiency exceeds the company's ₩310.1b market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

HANSHIN Engineering & Construction has a low net debt to EBITDA ratio of only 1.2. And its EBIT covers its interest expense a whopping 10.3 times over. So we're pretty relaxed about its super-conservative use of debt. But the other side of the story is that HANSHIN Engineering & Construction saw its EBIT decline by 3.7% over the last year. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since HANSHIN Engineering & Construction 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, HANSHIN Engineering & Construction's free cash flow amounted to 21% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Mulling over HANSHIN Engineering & Construction's attempt at staying on top of its total liabilities, we're certainly not enthusiastic. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Once we consider all the factors above, together, it seems to us that HANSHIN Engineering & Construction's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less 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. We've identified 4 warning signs with HANSHIN Engineering & Construction , and understanding them should be part of your investment process.

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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