SIMPAC (KRX:009160) Has A Somewhat Strained 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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, SIMPAC Inc. (KRX:009160) does carry debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for SIMPAC

What Is SIMPAC's Net Debt?

The chart below, which you can click on for greater detail, shows that SIMPAC had ₩112.9b in debt in September 2020; about the same as the year before. On the flip side, it has ₩105.0b in cash leading to net debt of about ₩7.90b.

A Look At SIMPAC's Liabilities

The latest balance sheet data shows that SIMPAC had liabilities of ₩220.3b due within a year, and liabilities of ₩17.6b falling due after that. Offsetting these obligations, it had cash of ₩105.0b as well as receivables valued at ₩58.0b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₩75.0b.

While this might seem like a lot, it is not so bad since SIMPAC has a market capitalization of ₩181.8b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Given net debt is only 0.50 times EBITDA, it is initially surprising to see that SIMPAC's EBIT has low interest coverage of 1.2 times. So while we're not necessarily alarmed we think that its debt is far from trivial. Importantly, SIMPAC's EBIT fell a jaw-dropping 88% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. 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 SIMPAC 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. Over the last three years, SIMPAC recorded free cash flow worth a fulsome 99% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Our View

We feel some trepidation about SIMPAC's difficulty EBIT growth rate, but we've got positives to focus on, too. To wit both its conversion of EBIT to free cash flow and net debt to EBITDA were encouraging signs. Looking at all the angles mentioned above, it does seem to us that SIMPAC is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example - SIMPAC has 3 warning signs we think 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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