Is Dongkuk Refractories & Steel (KOSDAQ:075970) Using Too Much Debt?

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.' 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, Dongkuk Refractories & Steel Co., Ltd. (KOSDAQ:075970) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own 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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Dongkuk Refractories & Steel

What Is Dongkuk Refractories & Steel's Debt?

As you can see below, Dongkuk Refractories & Steel had ₩20.0b of debt, at December 2020, which is about the same as the year before. You can click the chart for greater detail. However, it does have ₩16.0b in cash offsetting this, leading to net debt of about ₩4.03b.

How Healthy Is Dongkuk Refractories & Steel's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Dongkuk Refractories & Steel had liabilities of ₩32.0b due within 12 months and liabilities of ₩13.7b due beyond that. Offsetting these obligations, it had cash of ₩16.0b as well as receivables valued at ₩24.6b due within 12 months. So it has liabilities totalling ₩5.11b more than its cash and near-term receivables, combined.

Of course, Dongkuk Refractories & Steel has a market capitalization of ₩106.5b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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.

While Dongkuk Refractories & Steel's low debt to EBITDA ratio of 0.60 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 6.4 times last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. And we also note warmly that Dongkuk Refractories & Steel grew its EBIT by 16% last year, making its debt load easier to handle. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Dongkuk Refractories & Steel will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Happily for any shareholders, Dongkuk Refractories & Steel actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

The good news is that Dongkuk Refractories & Steel's demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. And that's just the beginning of the good news since its net debt to EBITDA is also very heartening. Zooming out, Dongkuk Refractories & Steel seems to use debt quite reasonably; and that gets the nod from us. While debt does bring risk, when used wisely it can also bring a higher return on equity. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For example - Dongkuk Refractories & Steel 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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