We Think Huvitz (KOSDAQ:065510) Is Taking Some Risk With Its 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.' 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. As with many other companies Huvitz Co., Ltd. (KOSDAQ:065510) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Huvitz

What Is Huvitz's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Huvitz had ₩82.7b of debt, an increase on ₩45.9b, over one year. On the flip side, it has ₩45.6b in cash leading to net debt of about ₩37.1b.

How Strong Is Huvitz's Balance Sheet?

We can see from the most recent balance sheet that Huvitz had liabilities of ₩78.8b falling due within a year, and liabilities of ₩20.0b due beyond that. Offsetting these obligations, it had cash of ₩45.6b as well as receivables valued at ₩15.0b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₩38.3b.

While this might seem like a lot, it is not so bad since Huvitz has a market capitalization of ₩79.9b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

With net debt to EBITDA of 2.9 Huvitz has a fairly noticeable amount of debt. But the high interest coverage of 7.2 suggests it can easily service that debt. Importantly, Huvitz's EBIT fell a jaw-dropping 21% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Huvitz 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Huvitz reported free cash flow worth 9.4% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

We'd go so far as to say Huvitz's EBIT growth rate was disappointing. But on the bright side, its interest cover is a good sign, and makes us more optimistic. We should also note that Medical Equipment industry companies like Huvitz commonly do use debt without problems. Looking at the bigger picture, it seems clear to us that Huvitz's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Like risks, for instance. Every company has them, and we've spotted 4 warning signs for Huvitz (of which 2 are significant!) you should know about.

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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