Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 Korea Industrial Co., Ltd. (KRX:002140) does use debt in its business. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Korea Industrial Carry?
As you can see below, at the end of December 2020, Korea Industrial had ₩81.6b of debt, up from ₩73.2b a year ago. Click the image for more detail. On the flip side, it has ₩17.1b in cash leading to net debt of about ₩64.4b.
A Look At Korea Industrial's Liabilities
According to the last reported balance sheet, Korea Industrial had liabilities of ₩100.5b due within 12 months, and liabilities of ₩13.4b due beyond 12 months. Offsetting this, it had ₩17.1b in cash and ₩42.6b in receivables that were due within 12 months. So it has liabilities totalling ₩54.2b more than its cash and near-term receivables, combined.
While this might seem like a lot, it is not so bad since Korea Industrial has a market capitalization of ₩105.6b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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 Korea Industrial's debt to EBITDA ratio of 5.1 suggests a heavy debt load, its interest coverage of 8.2 implies it services that debt with ease. Our best guess is that the company does indeed have significant debt obligations. It is well worth noting that Korea Industrial's EBIT shot up like bamboo after rain, gaining 63% in the last twelve months. That'll make it easier to manage its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Korea Industrial will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
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. During the last three years, Korea Industrial burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
Korea Industrial's conversion of EBIT to free cash flow and net debt to EBITDA definitely weigh on it, in our esteem. But its EBIT growth rate tells a very different story, and suggests some resilience. Looking at all the angles mentioned above, it does seem to us that Korea Industrial is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example Korea Industrial has 5 warning signs (and 2 which can't be ignored) we think 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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