We Think Hyundai Electric & Energy Systems (KRX:267260) 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. We note that Hyundai Electric & Energy Systems Co., Ltd. (KRX:267260) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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 step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Hyundai Electric & Energy Systems

What Is Hyundai Electric & Energy Systems's Net Debt?

As you can see below, Hyundai Electric & Energy Systems had ₩871.9b of debt at September 2020, down from ₩948.9b a year prior. However, it does have ₩606.9b in cash offsetting this, leading to net debt of about ₩265.0b.

A Look At Hyundai Electric & Energy Systems' Liabilities

The latest balance sheet data shows that Hyundai Electric & Energy Systems had liabilities of ₩1.47t due within a year, and liabilities of ₩261.8b falling due after that. Offsetting this, it had ₩606.9b in cash and ₩390.8b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₩736.9b.

Given this deficit is actually higher than the company's market capitalization of ₩640.7b, we think shareholders really should watch Hyundai Electric & Energy Systems's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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

Hyundai Electric & Energy Systems shareholders face the double whammy of a high net debt to EBITDA ratio (5.3), and fairly weak interest coverage, since EBIT is just 0.38 times the interest expense. This means we'd consider it to have a heavy debt load. One redeeming factor for Hyundai Electric & Energy Systems is that it turned last year's EBIT loss into a gain of ₩9.5b, over the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Hyundai Electric & Energy Systems's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

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. Over the last year, Hyundai Electric & Energy Systems actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

To be frank both Hyundai Electric & Energy Systems's net debt to EBITDA and its track record of covering its interest expense with its EBIT make us rather uncomfortable with its debt levels. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Once we consider all the factors above, together, it seems to us that Hyundai Electric & Energy Systems's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. Even though Hyundai Electric & Energy Systems 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.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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