TCC Steel (KRX:002710) Use Of Debt Could Be Considered Risky

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.' 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. We can see that TCC Steel Corp. (KRX:002710) does use debt in its business. But the real question is whether this debt is making the company risky.

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, 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. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for TCC Steel

How Much Debt Does TCC Steel Carry?

The chart below, which you can click on for greater detail, shows that TCC Steel had ₩139.2b in debt in September 2020; about the same as the year before. However, it also had ₩15.5b in cash, and so its net debt is ₩123.8b.

How Strong Is TCC Steel's Balance Sheet?

The latest balance sheet data shows that TCC Steel had liabilities of ₩180.8b due within a year, and liabilities of ₩23.7b falling due after that. On the other hand, it had cash of ₩15.5b and ₩60.5b worth of receivables due within a year. So its liabilities total ₩128.6b more than the combination of its cash and short-term receivables.

Given this deficit is actually higher than the company's market capitalization of ₩119.4b, we think shareholders really should watch TCC Steel's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

TCC Steel shareholders face the double whammy of a high net debt to EBITDA ratio (13.9), and fairly weak interest coverage, since EBIT is just 0.66 times the interest expense. This means we'd consider it to have a heavy debt load. Worse, TCC Steel's EBIT was down 87% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since TCC Steel 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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Considering the last three years, TCC Steel actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Our View

To be frank both TCC Steel's interest cover and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. And furthermore, its conversion of EBIT to free cash flow also fails to instill confidence. After considering the datapoints discussed, we think TCC Steel has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 4 warning signs for TCC Steel (1 makes us a bit uncomfortable!) that you should be aware of before investing here.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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