Here's Why Kwang Myung ElectricLtd (KRX:017040) Can Manage Its Debt Responsibly

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.' 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. Importantly, Kwang Myung Electric Co.,Ltd (KRX:017040) does carry debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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 examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Kwang Myung ElectricLtd

How Much Debt Does Kwang Myung ElectricLtd Carry?

As you can see below, Kwang Myung ElectricLtd had ₩11.2b of debt at December 2020, down from ₩16.2b a year prior. However, it does have ₩61.6b in cash offsetting this, leading to net cash of ₩50.4b.

How Strong Is Kwang Myung ElectricLtd's Balance Sheet?

We can see from the most recent balance sheet that Kwang Myung ElectricLtd had liabilities of ₩49.8b falling due within a year, and liabilities of ₩6.25b due beyond that. Offsetting this, it had ₩61.6b in cash and ₩15.1b in receivables that were due within 12 months. So it actually has ₩20.6b more liquid assets than total liabilities.

This surplus suggests that Kwang Myung ElectricLtd is using debt in a way that is appears to be both safe and conservative. Due to its strong net asset position, it is not likely to face issues with its lenders. Simply put, the fact that Kwang Myung ElectricLtd has more cash than debt is arguably a good indication that it can manage its debt safely.

It is just as well that Kwang Myung ElectricLtd's load is not too heavy, because its EBIT was down 47% over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Kwang Myung ElectricLtd 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Kwang Myung ElectricLtd may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the most recent three years, Kwang Myung ElectricLtd recorded free cash flow worth 60% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Summing up

While it is always sensible to investigate a company's debt, in this case Kwang Myung ElectricLtd has ₩50.4b in net cash and a decent-looking balance sheet. So we don't have any problem with Kwang Myung ElectricLtd's use of debt. 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. We've identified 3 warning signs with Kwang Myung ElectricLtd , and understanding them should be part of your investment process.

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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