Here's Why Lotte Chilsung BeverageLtd (KRX:005300) Is Weighed Down By Its Debt Load

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 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. We note that Lotte Chilsung Beverage Co.,Ltd. (KRX:005300) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Lotte Chilsung BeverageLtd

How Much Debt Does Lotte Chilsung BeverageLtd Carry?

The image below, which you can click on for greater detail, shows that at September 2020 Lotte Chilsung BeverageLtd had debt of ₩1.50t, up from ₩1.40t in one year. However, it also had ₩310.5b in cash, and so its net debt is ₩1.19t.

How Healthy Is Lotte Chilsung BeverageLtd's Balance Sheet?

According to the last reported balance sheet, Lotte Chilsung BeverageLtd had liabilities of ₩913.2b due within 12 months, and liabilities of ₩1.32t due beyond 12 months. Offsetting these obligations, it had cash of ₩310.5b as well as receivables valued at ₩322.0b due within 12 months. So it has liabilities totalling ₩1.60t more than its cash and near-term receivables, combined.

When you consider that this deficiency exceeds the company's ₩1.09t 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.

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). 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).

Lotte Chilsung BeverageLtd has a debt to EBITDA ratio of 4.9 and its EBIT covered its interest expense 2.7 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Worse, Lotte Chilsung BeverageLtd's EBIT was down 24% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Lotte Chilsung BeverageLtd 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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. 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, Lotte Chilsung BeverageLtd created free cash flow amounting to 9.4% 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 Lotte Chilsung BeverageLtd's level of total liabilities and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. And even its interest cover fails to inspire much confidence. Considering all the factors previously mentioned, we think that Lotte Chilsung BeverageLtd really is carrying too much debt. To us, that makes the stock rather risky, like walking through a dog park with your eyes closed. But some investors may feel differently. 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. Case in point: We've spotted 4 warning signs for Lotte Chilsung BeverageLtd you should be aware of, and 1 of them can't be ignored.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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