These 4 Measures Indicate That GS Engineering & Construction (KRX:006360) Is Using Debt Extensively

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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. Importantly, GS Engineering & Construction Corporation (KRX:006360) does carry debt. But the real question is whether this debt is making the company risky.

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. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for GS Engineering & Construction

What Is GS Engineering & Construction's Net Debt?

As you can see below, at the end of September 2020, GS Engineering & Construction had ₩3.32t of debt, up from ₩2.98t a year ago. Click the image for more detail. On the flip side, it has ₩2.37t in cash leading to net debt of about ₩943.6b.

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

We can see from the most recent balance sheet that GS Engineering & Construction had liabilities of ₩5.66t falling due within a year, and liabilities of ₩3.70t due beyond that. On the other hand, it had cash of ₩2.37t and ₩1.94t worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₩5.04t.

The deficiency here weighs heavily on the ₩3.06t company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. After all, GS Engineering & Construction would likely require a major re-capitalisation if it had to pay its creditors today.

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.

While GS Engineering & Construction's low debt to EBITDA ratio of 1.2 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 6.7 times last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. But the bad news is that GS Engineering & Construction has seen its EBIT plunge 18% in the last twelve months. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine GS Engineering & Construction's ability to maintain a healthy balance sheet going forward. 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 that EBIT is backed by free cash flow. During the last three years, GS Engineering & Construction produced sturdy free cash flow equating to 75% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

To be frank both GS Engineering & Construction's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Overall, we think it's fair to say that GS Engineering & Construction has enough debt that there are some real risks around the balance sheet. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. 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 4 warning signs for GS Engineering & Construction that you should be aware of.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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