Shinwha Intertek (KOSDAQ:056700) Has A Somewhat Strained Balance Sheet

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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Shinwha Intertek Corp. (KOSDAQ:056700) does use debt in its business. 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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Shinwha Intertek

How Much Debt Does Shinwha Intertek Carry?

The image below, which you can click on for greater detail, shows that Shinwha Intertek had debt of ₩38.7b at the end of September 2020, a reduction from ₩51.7b over a year. However, because it has a cash reserve of ₩10.9b, its net debt is less, at about ₩27.7b.

How Healthy Is Shinwha Intertek's Balance Sheet?

We can see from the most recent balance sheet that Shinwha Intertek had liabilities of ₩89.0b falling due within a year, and liabilities of ₩5.49b due beyond that. Offsetting these obligations, it had cash of ₩10.9b as well as receivables valued at ₩29.0b due within 12 months. So it has liabilities totalling ₩54.5b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of ₩86.5b, so it does suggest shareholders should keep an eye on Shinwha Intertek's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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).

Shinwha Intertek's net debt is sitting at a very reasonable 1.7 times its EBITDA, while its EBIT covered its interest expense just 4.0 times last year. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. Importantly, Shinwha Intertek's EBIT fell a jaw-dropping 75% 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. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Shinwha Intertek will need earnings to service that debt. 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 two years, Shinwha Intertek recorded free cash flow worth a fulsome 82% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Our View

Neither Shinwha Intertek's ability to grow its EBIT nor its interest cover gave us confidence in its ability to take on more debt. But the good news is it seems to be able to convert EBIT to free cash flow with ease. When we consider all the factors discussed, it seems to us that Shinwha Intertek is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. 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. Take risks, for example - Shinwha Intertek has 3 warning signs we think you should be aware of.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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