Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, COWAY Co., Ltd. (KRX:021240) does carry debt. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.
What Is COWAY's Debt?
You can click the graphic below for the historical numbers, but it shows that COWAY had ₩810.0b of debt in September 2020, down from ₩871.2b, one year before. However, because it has a cash reserve of ₩227.1b, its net debt is less, at about ₩583.0b.
How Healthy Is COWAY's Balance Sheet?
We can see from the most recent balance sheet that COWAY had liabilities of ₩1.49t falling due within a year, and liabilities of ₩159.2b due beyond that. Offsetting these obligations, it had cash of ₩227.1b as well as receivables valued at ₩570.4b due within 12 months. So it has liabilities totalling ₩855.5b more than its cash and near-term receivables, combined.
Given COWAY has a market capitalization of ₩4.69t, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). 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).
COWAY has a low net debt to EBITDA ratio of only 0.59. And its EBIT easily covers its interest expense, being 25.4 times the size. So we're pretty relaxed about its super-conservative use of debt. But the other side of the story is that COWAY saw its EBIT decline by 4.1% over the last year. That sort of decline, if sustained, will obviously make debt harder to handle. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if COWAY can strengthen its balance sheet over time. 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 that EBIT is backed by free cash flow. In the last three years, COWAY's free cash flow amounted to 36% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
When it comes to the balance sheet, the standout positive for COWAY was the fact that it seems able to cover its interest expense with its EBIT confidently. But the other factors we noted above weren't so encouraging. For example, its EBIT growth rate makes us a little nervous about its debt. When we consider all the elements mentioned above, it seems to us that COWAY is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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 1 warning sign with COWAY , and understanding them should be part of your investment process.
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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