Korea Shipbuilding & Offshore Engineering (KRX:009540) Takes On Some Risk With Its Use Of Debt

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 can see that Korea Shipbuilding & Offshore Engineering Co., Ltd. (KRX:009540) does use debt in its business. But should shareholders be worried about its use of debt?

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

See our latest analysis for Korea Shipbuilding & Offshore Engineering

What Is Korea Shipbuilding & Offshore Engineering's Debt?

The image below, which you can click on for greater detail, shows that at September 2020 Korea Shipbuilding & Offshore Engineering had debt of ₩6.85t, up from ₩4.38t in one year. However, because it has a cash reserve of ₩4.84t, its net debt is less, at about ₩2.01t.

How Strong Is Korea Shipbuilding & Offshore Engineering's Balance Sheet?

We can see from the most recent balance sheet that Korea Shipbuilding & Offshore Engineering had liabilities of ₩9.58t falling due within a year, and liabilities of ₩3.53t due beyond that. Offsetting this, it had ₩4.84t in cash and ₩1.32t in receivables that were due within 12 months. So its liabilities total ₩6.94t more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of ₩7.64t. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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

Korea Shipbuilding & Offshore Engineering has net debt worth 2.4 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 3.1 times the interest expense. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. However, the silver lining was that Korea Shipbuilding & Offshore Engineering achieved a positive EBIT of ₩425b in the last twelve months, an improvement on the prior year's loss. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Korea Shipbuilding & Offshore Engineering 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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. During the last year, Korea Shipbuilding & Offshore Engineering burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

We'd go so far as to say Korea Shipbuilding & Offshore Engineering's conversion of EBIT to free cash flow was disappointing. Having said that, its ability to grow its EBIT isn't such a worry. Overall, it seems to us that Korea Shipbuilding & Offshore Engineering's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Take risks, for example - Korea Shipbuilding & Offshore Engineering has 2 warning signs (and 1 which is concerning) we think you should know about.

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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