HSD Engine (KRX:082740) Use Of Debt Could Be Considered Risky

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.' 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. As with many other companies HSD Engine Co., Ltd. (KRX:082740) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for HSD Engine

What Is HSD Engine's Debt?

The chart below, which you can click on for greater detail, shows that HSD Engine had ₩258.7b in debt in September 2020; about the same as the year before. On the flip side, it has ₩49.8b in cash leading to net debt of about ₩208.9b.

How Strong Is HSD Engine's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that HSD Engine had liabilities of ₩547.8b due within 12 months and liabilities of ₩27.5b due beyond that. Offsetting this, it had ₩49.8b in cash and ₩74.5b in receivables that were due within 12 months. So its liabilities total ₩450.9b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the ₩284.3b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. At the end of the day, HSD Engine would probably need a major re-capitalization if its creditors were to demand repayment.

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.

Weak interest cover of 0.93 times and a disturbingly high net debt to EBITDA ratio of 6.4 hit our confidence in HSD Engine like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. However, the silver lining was that HSD Engine achieved a positive EBIT of ₩14b in the last twelve months, an improvement on the prior year's loss. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if HSD Engine 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. In the last year, HSD Engine created free cash flow amounting to 7.0% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

On the face of it, HSD Engine's net debt to EBITDA left us tentative about the stock, and its interest cover 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. Taking into account all the aforementioned factors, it looks like HSD Engine has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. 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. For example, we've discovered 1 warning sign for HSD Engine that you should be aware of before investing here.

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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