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. 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 can see that E-MART Inc. (KRX:139480) does use debt in its business. 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. If things get really bad, the lenders can take control of the business. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company’s use of debt, we first look at cash and debt together.
What Is E-MART’s Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of September 2019 E-MART had ₩3.99t of debt, an increase on ₩3.89m, over one year. However, it also had ₩1.47t in cash, and so its net debt is ₩2.52t.
How Strong Is E-MART’s Balance Sheet?
According to the last reported balance sheet, E-MART had liabilities of ₩5.52t due within 12 months, and liabilities of ₩5.30t due beyond 12 months. Offsetting these obligations, it had cash of ₩1.47t as well as receivables valued at ₩17.2b due within 12 months. So its liabilities total ₩9.34t more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the ₩3.36t company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, E-MART would likely require a major re-capitalisation if it had to pay its creditors today.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
E-MART has net debt worth 2.5 times EBITDA, which isn’t too much, but its interest cover looks a bit on the low side, with EBIT at only 3.9 times the interest expense. In large part that’s due to the company’s significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. Shareholders should be aware that E-MART’s EBIT was down 58% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. 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 E-MART can strengthen its balance sheet over time. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, E-MART burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
To be frank both E-MART’s EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. Having said that, its ability handle its debt, based on its EBITDA, isn’t such a worry. Considering all the factors previously mentioned, we think that E-MART really is carrying too much debt. To our minds, that means the stock is rather high risk, and probably one to avoid; but to each their own (investing) style. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet – far from it. Consider risks, for instance. Every company has them, and we’ve spotted 2 warning signs for E-MART you should know about.
At the end of the day, it’s often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It’s free.
If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.
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