Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 Wonik Corporation (KOSDAQ:032940) does have debt on its balance sheet. But is this debt a concern to shareholders?
When Is Debt Dangerous?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.
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What Is Wonik's Debt?
As you can see below, Wonik had ₩37.8b of debt at September 2020, down from ₩41.0b a year prior. However, because it has a cash reserve of ₩10.9b, its net debt is less, at about ₩26.8b.
How Healthy Is Wonik's Balance Sheet?
We can see from the most recent balance sheet that Wonik had liabilities of ₩47.2b falling due within a year, and liabilities of ₩19.6b due beyond that. Offsetting these obligations, it had cash of ₩10.9b as well as receivables valued at ₩14.2b due within 12 months. So its liabilities total ₩41.6b more than the combination of its cash and short-term receivables.
This deficit isn't so bad because Wonik is worth ₩87.6b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (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).
Wonik has a debt to EBITDA ratio of 3.1 and its EBIT covered its interest expense 5.1 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Notably, Wonik's EBIT launched higher than Elon Musk, gaining a whopping 233% on last year. When analysing debt levels, the balance sheet is the obvious place to start. But it is Wonik's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the most recent three years, Wonik recorded free cash flow worth 75% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Our View
The good news is that Wonik's demonstrated ability to grow its EBIT delights us like a fluffy puppy does a toddler. But, on a more sombre note, we are a little concerned by its net debt to EBITDA. We would also note that Healthcare industry companies like Wonik commonly do use debt without problems. When we consider the range of factors above, it looks like Wonik is pretty sensible with its use of debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. 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 instance, we've identified 3 warning signs for Wonik that you should be aware of.
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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About KOSDAQ:A032940
Wonik
Engages in the semiconductor, trade and distribution, finance, cosmetics, IT and electronic parts, robots, and leisure businesses in South Korea.
Good value with mediocre balance sheet.