Here's Why SK Discovery (KRX:006120) Has A Meaningful Debt Burden

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 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. As with many other companies SK Discovery Co., Ltd. (KRX:006120) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for SK Discovery

What Is SK Discovery's Debt?

The image below, which you can click on for greater detail, shows that at September 2020 SK Discovery had debt of ₩1.86t, up from ₩1.33t in one year. However, it does have ₩1.18t in cash offsetting this, leading to net debt of about ₩677.0b.

How Strong Is SK Discovery's Balance Sheet?

We can see from the most recent balance sheet that SK Discovery had liabilities of ₩1.33t falling due within a year, and liabilities of ₩1.56t due beyond that. Offsetting this, it had ₩1.18t in cash and ₩602.6b in receivables that were due within 12 months. So its liabilities total ₩1.11t more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of ₩1.30t, so it does suggest shareholders should keep an eye on SK Discovery's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

SK Discovery's net debt is sitting at a very reasonable 2.0 times its EBITDA, while its EBIT covered its interest expense just 5.3 times last year. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. It is well worth noting that SK Discovery's EBIT shot up like bamboo after rain, gaining 40% in the last twelve months. That'll make it easier to manage its debt. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since SK Discovery will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, SK Discovery burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Neither SK Discovery's ability to convert EBIT to free cash flow nor its level of total liabilities gave us confidence in its ability to take on more debt. But the good news is it seems to be able to grow its EBIT with ease. When we consider all the factors discussed, it seems to us that SK Discovery is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Be aware that SK Discovery is showing 1 warning sign in our investment analysis , you should know about...

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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