We Think hyungji Elite (KRX:093240) Can Stay On Top Of 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.' 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 hyungji Elite Co., Ltd. (KRX:093240) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for hyungji Elite

How Much Debt Does hyungji Elite Carry?

You can click the graphic below for the historical numbers, but it shows that hyungji Elite had ₩22.0b of debt in December 2020, down from ₩27.3b, one year before. On the flip side, it has ₩14.2b in cash leading to net debt of about ₩7.85b.

How Strong Is hyungji Elite's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that hyungji Elite had liabilities of ₩46.7b due within 12 months and liabilities of ₩11.1b due beyond that. On the other hand, it had cash of ₩14.2b and ₩41.0b worth of receivables due within a year. So it has liabilities totalling ₩2.65b more than its cash and near-term receivables, combined.

Given hyungji Elite has a market capitalization of ₩118.0b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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).

While hyungji Elite has a quite reasonable net debt to EBITDA multiple of 2.3, its interest cover seems weak, at 0.79. In large part that's it has so much depreciation and amortisation. These charges may be non-cash, so they could be excluded when it comes to paying down debt. But the accounting charges are there for a reason -- some assets are seen to be losing value. Either way there's no doubt the stock is using meaningful leverage. Notably, hyungji Elite made a loss at the EBIT level, last year, but improved that to positive EBIT of ₩995m in the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But it is hyungji Elite'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 it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, hyungji Elite actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

The good news is that hyungji Elite's demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. But we must concede we find its interest cover has the opposite effect. All these things considered, it appears that hyungji Elite can comfortably handle its current debt levels. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that hyungji Elite is showing 2 warning signs in our investment analysis , you should know about...

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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