We Think STX Heavy Industries (KRX:071970) Is Taking Some Risk With Its Debt

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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, STX Heavy Industries Co., Ltd. (KRX:071970) does carry debt. But should shareholders be worried about its use of debt?

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. If things get really bad, the lenders can take control of the business. 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. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for STX Heavy Industries

What Is STX Heavy Industries's Debt?

As you can see below, STX Heavy Industries had ₩87.3b of debt at September 2023, down from ₩119.2b a year prior. However, because it has a cash reserve of ₩22.9b, its net debt is less, at about ₩64.4b.

How Strong Is STX Heavy Industries' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that STX Heavy Industries had liabilities of ₩195.0b due within 12 months and liabilities of ₩38.6b due beyond that. Offsetting this, it had ₩22.9b in cash and ₩54.6b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₩156.1b.

While this might seem like a lot, it is not so bad since STX Heavy Industries has a market capitalization of ₩329.2b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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.

STX Heavy Industries has a debt to EBITDA ratio of 3.0 and its EBIT covered its interest expense 4.0 times. 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 STX Heavy Industries grew its EBIT by 115% 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 you can't view debt in total isolation; since STX Heavy Industries 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. So it's worth checking how much of that EBIT is backed by free cash flow. During the last two years, STX Heavy Industries burned a lot of cash. 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

Neither STX Heavy Industries's ability to convert EBIT to free cash flow nor its interest cover gave us confidence in its ability to take on more debt. But its EBIT growth rate tells a very different story, and suggests some resilience. When we consider all the factors discussed, it seems to us that STX Heavy Industries is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 2 warning signs for STX Heavy Industries you should be aware of.

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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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.