Gyeongnam Steel (KOSDAQ:039240) Seems To Use Debt Quite Sensibly

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 Gyeongnam Steel Co., Ltd (KOSDAQ:039240) does have debt on its balance sheet. But is this debt a concern to shareholders?

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, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Gyeongnam Steel

What Is Gyeongnam Steel's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Gyeongnam Steel had ₩22.7b of debt, an increase on ₩21.3b, over one year. However, it also had ₩16.2b in cash, and so its net debt is ₩6.55b.

How Strong Is Gyeongnam Steel's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Gyeongnam Steel had liabilities of ₩58.4b due within 12 months and liabilities of ₩3.77b due beyond that. Offsetting this, it had ₩16.2b in cash and ₩47.9b in receivables that were due within 12 months. So it actually has ₩1.84b more liquid assets than total liabilities.

This short term liquidity is a sign that Gyeongnam Steel could probably pay off its debt with ease, as its balance sheet is far from stretched.

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).

Gyeongnam Steel's net debt is only 0.94 times its EBITDA. And its EBIT easily covers its interest expense, being 10.8 times the size. So we're pretty relaxed about its super-conservative use of debt. It is just as well that Gyeongnam Steel's load is not too heavy, because its EBIT was down 21% 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 it is Gyeongnam Steel'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Gyeongnam Steel actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

The good news is that Gyeongnam Steel's demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. But we must concede we find its EBIT growth rate has the opposite effect. Looking at all the aforementioned factors together, it strikes us that Gyeongnam Steel can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. 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. We've identified 2 warning signs with Gyeongnam Steel (at least 1 which is significant) , and understanding them should be part of your investment process.

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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