These 4 Measures Indicate That Samsung Heavy Industries (KRX:010140) Is Using Debt In A Risky Way

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 can see that Samsung Heavy Industries Co., Ltd. (KRX:010140) does use debt in its business. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.

View our latest analysis for Samsung Heavy Industries

What Is Samsung Heavy Industries's Net Debt?

As you can see below, at the end of December 2023, Samsung Heavy Industries had ₩3.55t of debt, up from ₩3.06t a year ago. Click the image for more detail. However, it also had ₩808.4b in cash, and so its net debt is ₩2.74t.

How Healthy Is Samsung Heavy Industries' Balance Sheet?

We can see from the most recent balance sheet that Samsung Heavy Industries had liabilities of ₩11t falling due within a year, and liabilities of ₩952.3b due beyond that. On the other hand, it had cash of ₩808.4b and ₩546.3b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₩11t.

Given this deficit is actually higher than the company's market capitalization of ₩8.41t, we think shareholders really should watch Samsung Heavy Industries's debt levels, like a parent watching their child ride a bike for the first time. 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 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Samsung Heavy Industries shareholders face the double whammy of a high net debt to EBITDA ratio (5.8), and fairly weak interest coverage, since EBIT is just 1.6 times the interest expense. The debt burden here is substantial. One redeeming factor for Samsung Heavy Industries is that it turned last year's EBIT loss into a gain of ₩233b, over the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Samsung Heavy Industries can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, Samsung Heavy Industries saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

On the face of it, Samsung Heavy Industries's net debt to EBITDA left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But at least its EBIT growth rate is not so bad. After considering the datapoints discussed, we think Samsung Heavy Industries has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. Even though Samsung Heavy Industries lost money on the bottom line, its positive EBIT suggests the business itself has potential. So you might want to check out how earnings have been trending over the last few years.

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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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.