Does KG Chemical (KRX:001390) Have A Healthy Balance Sheet?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 KG Chemical Corporation (KRX:001390) makes use of debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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. 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, 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 KG Chemical

How Much Debt Does KG Chemical Carry?

You can click the graphic below for the historical numbers, but it shows that KG Chemical had ₩1.50t of debt in September 2020, down from ₩1.83t, one year before. However, because it has a cash reserve of ₩307.6b, its net debt is less, at about ₩1.19t.

A Look At KG Chemical's Liabilities

We can see from the most recent balance sheet that KG Chemical had liabilities of ₩1.37t falling due within a year, and liabilities of ₩1.25t due beyond that. Offsetting this, it had ₩307.6b in cash and ₩412.0b in receivables that were due within 12 months. So its liabilities total ₩1.89t more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the ₩311.3b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. At the end of the day, KG Chemical would probably need a major re-capitalization if its creditors were to demand repayment.

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.

KG Chemical's debt is 3.7 times its EBITDA, and its EBIT cover its interest expense 6.4 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Pleasingly, KG Chemical is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 152% gain in the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But it is KG Chemical'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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, KG Chemical generated free cash flow amounting to a very robust 87% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Our View

While KG Chemical's level of total liabilities has us nervous. To wit both its conversion of EBIT to free cash flow and EBIT growth rate were encouraging signs. Looking at all the angles mentioned above, it does seem to us that KG Chemical is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that KG Chemical is showing 3 warning signs in our investment analysis , and 1 of those shouldn't be ignored...

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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