Amorepacific (KRX:090430) Seems To Use Debt Quite Sensibly

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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Amorepacific Corporation (KRX:090430) does carry 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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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.

View our latest analysis for Amorepacific

What Is Amorepacific's Net Debt?

The image below, which you can click on for greater detail, shows that at December 2020 Amorepacific had debt of ₩154.2b, up from ₩99.3b in one year. But on the other hand it also has ₩1.02t in cash, leading to a ₩863.9b net cash position.

How Strong Is Amorepacific's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Amorepacific had liabilities of ₩965.9b due within 12 months and liabilities of ₩271.6b due beyond that. Offsetting these obligations, it had cash of ₩1.02t as well as receivables valued at ₩298.4b due within 12 months. So it actually has ₩78.9b more liquid assets than total liabilities.

Having regard to Amorepacific's size, it seems that its liquid assets are well balanced with its total liabilities. So it's very unlikely that the ₩15t company is short on cash, but still worth keeping an eye on the balance sheet. Simply put, the fact that Amorepacific has more cash than debt is arguably a good indication that it can manage its debt safely.

It is just as well that Amorepacific's load is not too heavy, because its EBIT was down 66% over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Amorepacific 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. While Amorepacific has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last three years, Amorepacific recorded free cash flow worth a fulsome 92% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Summing up

While it is always sensible to investigate a company's debt, in this case Amorepacific has ₩863.9b in net cash and a decent-looking balance sheet. The cherry on top was that in converted 92% of that EBIT to free cash flow, bringing in ₩340b. So we don't have any problem with Amorepacific's use of debt. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Amorepacific you should know about.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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