Is SK Innovation (KRX:096770) Using Too Much 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.' 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. We can see that SK Innovation Co., Ltd. (KRX:096770) does use debt in its business. But the more important question is: how much risk is that debt creating?

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. 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.

Check out our latest analysis for SK Innovation

What Is SK Innovation's Net Debt?

As you can see below, at the end of September 2020, SK Innovation had ₩15t of debt, up from ₩11t a year ago. Click the image for more detail. On the flip side, it has ₩4.91t in cash leading to net debt of about ₩9.62t.

How Healthy Is SK Innovation's Balance Sheet?

The latest balance sheet data shows that SK Innovation had liabilities of ₩11t due within a year, and liabilities of ₩13t falling due after that. Offsetting these obligations, it had cash of ₩4.91t as well as receivables valued at ₩3.40t due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₩15t.

When you consider that this deficiency exceeds the company's huge ₩15t market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if SK Innovation 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.

Over 12 months, SK Innovation made a loss at the EBIT level, and saw its revenue drop to ₩39t, which is a fall of 25%. That makes us nervous, to say the least.

Caveat Emptor

While SK Innovation's falling revenue is about as heartwarming as a wet blanket, arguably its earnings before interest and tax (EBIT) loss is even less appealing. Indeed, it lost a very considerable ₩2.1t at the EBIT level. When we look at that alongside the significant liabilities, we're not particularly confident about the company. We'd want to see some strong near-term improvements before getting too interested in the stock. Not least because it burned through ₩1.8t in negative free cash flow over the last year. So suffice it to say we consider the stock to be risky. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 3 warning signs for SK Innovation (1 makes us a bit uncomfortable!) that you should be aware of before investing here.

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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