Is Dongkuk Steel Mill (KRX:001230) 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. As with many other companies Dongkuk Steel Mill Company Limited (KRX:001230) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Dongkuk Steel Mill

What Is Dongkuk Steel Mill's Net Debt?

The image below, which you can click on for greater detail, shows that Dongkuk Steel Mill had debt of ₩2.40t at the end of September 2020, a reduction from ₩2.82t over a year. However, it does have ₩417.0b in cash offsetting this, leading to net debt of about ₩1.99t.

A Look At Dongkuk Steel Mill's Liabilities

We can see from the most recent balance sheet that Dongkuk Steel Mill had liabilities of ₩2.73t falling due within a year, and liabilities of ₩495.5b due beyond that. On the other hand, it had cash of ₩417.0b and ₩630.0b worth of receivables due within a year. So it has liabilities totalling ₩2.18t more than its cash and near-term receivables, combined.

This deficit casts a shadow over the ₩720.8b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Dongkuk Steel Mill would likely require a major re-capitalisation if it had to pay its creditors today.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While we wouldn't worry about Dongkuk Steel Mill's net debt to EBITDA ratio of 4.6, we think its super-low interest cover of 2.5 times is a sign of high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Even more troubling is the fact that Dongkuk Steel Mill actually let its EBIT decrease by 3.2% over the last year. If it keeps going like that paying off its debt will be like running on a treadmill -- a lot of effort for not much advancement. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Dongkuk Steel Mill's ability to maintain a healthy balance sheet going forward. 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 always check how much of that EBIT is translated into free cash flow. Happily for any shareholders, Dongkuk Steel Mill actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

We'd go so far as to say Dongkuk Steel Mill's level of total liabilities was disappointing. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Overall, we think it's fair to say that Dongkuk Steel Mill has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. Even though Dongkuk Steel Mill lost money on the bottom line, its positive EBIT suggests the business itself has potential. So you might want to check out how earnings have been trending over the last few years.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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