Is LOTTE Fine Chemical (KRX:004000) A Risky Investment?

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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that LOTTE Fine Chemical Co., Ltd. (KRX:004000) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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 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. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for LOTTE Fine Chemical

What Is LOTTE Fine Chemical's Debt?

You can click the graphic below for the historical numbers, but it shows that LOTTE Fine Chemical had ₩2.05b of debt in September 2020, down from ₩81.3b, one year before. But on the other hand it also has ₩469.7b in cash, leading to a ₩467.7b net cash position.

A Look At LOTTE Fine Chemical's Liabilities

According to the last reported balance sheet, LOTTE Fine Chemical had liabilities of ₩222.4b due within 12 months, and liabilities of ₩22.1b due beyond 12 months. On the other hand, it had cash of ₩469.7b and ₩207.8b worth of receivables due within a year. So it can boast ₩432.9b more liquid assets than total liabilities.

This surplus liquidity suggests that LOTTE Fine Chemical's balance sheet could take a hit just as well as Homer Simpson's head can take a punch. With this in mind one could posit that its balance sheet means the company is able to handle some adversity. Simply put, the fact that LOTTE Fine Chemical has more cash than debt is arguably a good indication that it can manage its debt safely.

On the other hand, LOTTE Fine Chemical's EBIT dived 11%, over the last year. If that rate of decline in earnings continues, the company could find itself in a tight spot. 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 LOTTE Fine Chemical'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 business needs free cash flow to pay off debt; accounting profits just don't cut it. LOTTE Fine Chemical may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last three years, LOTTE Fine Chemical generated free cash flow amounting to a very robust 86% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that LOTTE Fine Chemical has net cash of ₩467.7b, as well as more liquid assets than liabilities. The cherry on top was that in converted 86% of that EBIT to free cash flow, bringing in ₩104b. So is LOTTE Fine Chemical's debt a risk? It doesn't seem so to us. Another positive for shareholders is that it pays dividends. So if you like receiving those dividend payments, check LOTTE Fine Chemical's dividend history, without delay!

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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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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