These 4 Measures Indicate That ESTec (KOSDAQ:069510) Is Using Debt Safely

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that ESTec Corporation (KOSDAQ:069510) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for ESTec

What Is ESTec's Net Debt?

The image below, which you can click on for greater detail, shows that at December 2020 ESTec had debt of ₩10.4b, up from ₩8.48b in one year. However, it does have ₩74.3b in cash offsetting this, leading to net cash of ₩64.0b.

A Look At ESTec's Liabilities

According to the last reported balance sheet, ESTec had liabilities of ₩62.8b due within 12 months, and liabilities of ₩5.02b due beyond 12 months. Offsetting this, it had ₩74.3b in cash and ₩55.9b in receivables that were due within 12 months. So it can boast ₩62.4b more liquid assets than total liabilities.

This surplus liquidity suggests that ESTec's balance sheet could take a hit just as well as Homer Simpson's head can take a punch. With this in mind one could posit that its balance sheet means the company is able to handle some adversity. Simply put, the fact that ESTec has more cash than debt is arguably a good indication that it can manage its debt safely.

In fact ESTec's saving grace is its low debt levels, because its EBIT has tanked 24% in the last twelve months. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since ESTec 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. ESTec may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the most recent three years, ESTec recorded free cash flow worth 68% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Summing up

While it is always sensible to investigate a company's debt, in this case ESTec has ₩64.0b in net cash and a decent-looking balance sheet. And it impressed us with free cash flow of ₩5.0b, being 68% of its EBIT. So is ESTec's debt a risk? It doesn't seem so to us. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 2 warning signs with ESTec , and understanding them should be part of your investment process.

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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