These 4 Measures Indicate That Dongwha EnterpriseLtd (KOSDAQ:025900) Is Using Debt Extensively

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.' 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. Importantly, Dongwha Enterprise Co.,Ltd (KOSDAQ:025900) does carry debt. But should shareholders be worried about its use of debt?

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. If things get really bad, the lenders can take control of the business. 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 Dongwha EnterpriseLtd

What Is Dongwha EnterpriseLtd's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Dongwha EnterpriseLtd had ₩572.6b of debt, an increase on ₩545.9b, over one year. However, it also had ₩144.9b in cash, and so its net debt is ₩427.7b.

How Healthy Is Dongwha EnterpriseLtd's Balance Sheet?

The latest balance sheet data shows that Dongwha EnterpriseLtd had liabilities of ₩421.2b due within a year, and liabilities of ₩403.0b falling due after that. Offsetting these obligations, it had cash of ₩144.9b as well as receivables valued at ₩96.1b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₩583.2b.

This deficit isn't so bad because Dongwha EnterpriseLtd is worth ₩1.13t, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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

Dongwha EnterpriseLtd has a debt to EBITDA ratio of 3.8 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 Dongwha EnterpriseLtd's EBIT was pretty flat over the last year. We would prefer to see some earnings growth, because that always helps diminish debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Dongwha EnterpriseLtd 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Dongwha EnterpriseLtd reported free cash flow worth 14% 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

While Dongwha EnterpriseLtd's net debt to EBITDA makes us cautious about it, its track record of converting EBIT to free cash flow is no better. But its not so bad at growing its EBIT. Taking the abovementioned factors together we do think Dongwha EnterpriseLtd's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. Be aware that Dongwha EnterpriseLtd is showing 3 warning signs in our investment analysis , you should know about...

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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