Does Korea Aerospace Industries (KRX:047810) Have A Healthy Balance Sheet?

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.' 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 Korea Aerospace Industries, Ltd. (KRX:047810) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Korea Aerospace Industries

How Much Debt Does Korea Aerospace Industries Carry?

As you can see below, at the end of September 2020, Korea Aerospace Industries had ₩847.8b of debt, up from ₩660.0b a year ago. Click the image for more detail. On the flip side, it has ₩373.3b in cash leading to net debt of about ₩474.5b.

A Look At Korea Aerospace Industries' Liabilities

Zooming in on the latest balance sheet data, we can see that Korea Aerospace Industries had liabilities of ₩2.56t due within 12 months and liabilities of ₩997.5b due beyond that. Offsetting this, it had ₩373.3b in cash and ₩257.3b in receivables that were due within 12 months. So its liabilities total ₩2.92t more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of ₩3.67t. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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

Korea Aerospace Industries's net debt is only 1.3 times its EBITDA. And its EBIT covers its interest expense a whopping 15.5 times over. So we're pretty relaxed about its super-conservative use of debt. But the bad news is that Korea Aerospace Industries has seen its EBIT plunge 16% in the last twelve months. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. 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 Korea Aerospace Industries 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last two years, Korea Aerospace Industries reported free cash flow worth 5.4% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

To be frank both Korea Aerospace Industries's conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Korea Aerospace Industries stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 5 warning signs for Korea Aerospace Industries 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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