S-Oil (KRX:010950) Use Of Debt Could Be Considered Risky

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies S-Oil Corporation (KRX:010950) makes use of debt. But the more important question is: how much risk is that debt creating?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for S-Oil

What Is S-Oil's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2024 S-Oil had debt of ₩7.15t, up from ₩5.62t in one year. However, it also had ₩1.62t in cash, and so its net debt is ₩5.53t.

How Healthy Is S-Oil's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that S-Oil had liabilities of ₩10t due within 12 months and liabilities of ₩3.40t due beyond that. On the other hand, it had cash of ₩1.62t and ₩2.00t worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₩10t.

Given this deficit is actually higher than the company's market capitalization of ₩7.01t, we think shareholders really should watch S-Oil's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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.

S-Oil shareholders face the double whammy of a high net debt to EBITDA ratio (6.2), and fairly weak interest coverage, since EBIT is just 2.0 times the interest expense. The debt burden here is substantial. Worse, S-Oil's EBIT was down 66% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if S-Oil 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, S-Oil created free cash flow amounting to 12% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

To be frank both S-Oil's net debt to EBITDA and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. And furthermore, its interest cover also fails to instill confidence. We think the chances that S-Oil has too much debt a very significant. To us, that makes the stock rather risky, like walking through a dog park with your eyes closed. But some investors may feel differently. 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. For instance, we've identified 2 warning signs for S-Oil that you should be aware of.

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. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.