These 4 Measures Indicate That Dongwon Industries (KRX:006040) Is Using Debt Reasonably Well

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 Dongwon Industries Co., Ltd. (KRX:006040) does use debt in its business. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Dongwon Industries

What Is Dongwon Industries's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Dongwon Industries had ₩1.06t of debt in December 2020, down from ₩1.13t, one year before. However, it does have ₩316.2b in cash offsetting this, leading to net debt of about ₩744.7b.

A Look At Dongwon Industries' Liabilities

We can see from the most recent balance sheet that Dongwon Industries had liabilities of ₩1.06t falling due within a year, and liabilities of ₩750.2b due beyond that. Offsetting this, it had ₩316.2b in cash and ₩331.8b in receivables that were due within 12 months. So it has liabilities totalling ₩1.16t more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of ₩912.5b, we think shareholders really should watch Dongwon Industries's debt levels, like a parent watching their child ride a bike for the first time. 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).

Dongwon Industries's net debt of 1.7 times EBITDA suggests graceful use of debt. And the fact that its trailing twelve months of EBIT was 7.8 times its interest expenses harmonizes with that theme. It is well worth noting that Dongwon Industries's EBIT shot up like bamboo after rain, gaining 63% in the last twelve months. That'll make it easier to manage its 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 Dongwon Industries 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, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Dongwon Industries produced sturdy free cash flow equating to 61% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

When it comes to the balance sheet, the standout positive for Dongwon Industries was the fact that it seems able to grow its EBIT confidently. However, our other observations weren't so heartening. In particular, level of total liabilities gives us cold feet. Looking at all this data makes us feel a little cautious about Dongwon Industries's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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. For instance, we've identified 3 warning signs for Dongwon Industries (1 shouldn't be ignored) you should be aware of.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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