Howard Marks put it nicely when he said that, rather than worrying about share price volatility, ‘The possibility of permanent loss is the risk I worry about… and every practical investor I know worries about. It’s only natural to consider a company’s balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies ILJIN Holdings Co., Ltd. (KRX:015860) makes use of debt. But the more important question is: how much risk is that debt creating?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is ILJIN Holdings’s Net Debt?
As you can see below, at the end of September 2019, ILJIN Holdings had ₩390.4b of debt, up from ₩389.2k a year ago. Click the image for more detail. However, because it has a cash reserve of ₩156.6b, its net debt is less, at about ₩233.8b.
How Healthy Is ILJIN Holdings’s Balance Sheet?
According to the last reported balance sheet, ILJIN Holdings had liabilities of ₩441.2b due within 12 months, and liabilities of ₩235.3b due beyond 12 months. Offsetting these obligations, it had cash of ₩156.6b as well as receivables valued at ₩185.8b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₩334.1b.
Given this deficit is actually higher than the company’s market capitalization of ₩233.6b, we think shareholders really should watch ILJIN Holdings’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.
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). 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).
ILJIN Holdings’s debt is 3.5 times its EBITDA, and its EBIT cover its interest expense 3.2 times over. Taken together this implies that, while we wouldn’t want to see debt levels rise, we think it can handle its current leverage. The silver lining is that ILJIN Holdings grew its EBIT by 205% last year, which nourishing like the idealism of youth. If that earnings trend continues it will make its debt load much more manageable in the future. There’s no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine ILJIN Holdings’s ability to maintain a healthy balance sheet going forward. 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 company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, ILJIN Holdings reported free cash flow worth 6.0% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.
Mulling over ILJIN Holdings’s attempt at staying on top of its total liabilities, we’re certainly not enthusiastic. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Looking at the bigger picture, it seems clear to us that ILJIN Holdings’s use of debt is creating risks for the company. 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. However, not all investment risk resides within the balance sheet – far from it. For instance, we’ve identified 2 warning signs for ILJIN Holdings (1 is significant) 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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