Does Hanjin Heavy Industries & Construction (KRX:097230) Have A Healthy Balance Sheet?

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.' 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. We note that Hanjin Heavy Industries & Construction Co., Ltd. (KRX:097230) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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 think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Hanjin Heavy Industries & Construction

What Is Hanjin Heavy Industries & Construction's Debt?

As you can see below, Hanjin Heavy Industries & Construction had ₩759.6b of debt at September 2020, down from ₩1.16t a year prior. However, it does have ₩155.2b in cash offsetting this, leading to net debt of about ₩604.4b.

How Healthy Is Hanjin Heavy Industries & Construction's Balance Sheet?

The latest balance sheet data shows that Hanjin Heavy Industries & Construction had liabilities of ₩1.52t due within a year, and liabilities of ₩301.6b falling due after that. Offsetting these obligations, it had cash of ₩155.2b as well as receivables valued at ₩73.4b due within 12 months. So it has liabilities totalling ₩1.59t more than its cash and near-term receivables, combined.

This deficit casts a shadow over the ₩748.6b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Hanjin Heavy Industries & Construction would likely require a major re-capitalisation if it had to pay its creditors today.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).

While we wouldn't worry about Hanjin Heavy Industries & Construction's net debt to EBITDA ratio of 4.2, we think its super-low interest cover of 2.0 times is a sign of high leverage. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. The silver lining is that Hanjin Heavy Industries & Construction grew its EBIT by 142% 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 Hanjin Heavy Industries & Construction's earnings that will influence how the balance sheet holds up in the future. 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 we always check how much of that EBIT is translated into free cash flow. Happily for any shareholders, Hanjin Heavy Industries & Construction actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

We feel some trepidation about Hanjin Heavy Industries & Construction's difficulty level of total liabilities, but we've got positives to focus on, too. To wit both its conversion of EBIT to free cash flow and EBIT growth rate were encouraging signs. When we consider all the factors discussed, it seems to us that Hanjin Heavy Industries & Construction is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. Even though Hanjin Heavy Industries & Construction lost money on the bottom line, its positive EBIT suggests the business itself has potential. So you might want to check out how earnings have been trending over the last few years.

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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