We Think Samhwa Crown & Closure (KRX:004450) Is Taking Some Risk With Its Debt

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 note that Samhwa Crown & Closure Co., Ltd (KRX:004450) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Samhwa Crown & Closure

What Is Samhwa Crown & Closure's Net Debt?

As you can see below, at the end of September 2020, Samhwa Crown & Closure had ₩75.1b of debt, up from ₩62.0b a year ago. Click the image for more detail. However, because it has a cash reserve of ₩23.6b, its net debt is less, at about ₩51.6b.

How Strong Is Samhwa Crown & Closure's Balance Sheet?

The latest balance sheet data shows that Samhwa Crown & Closure had liabilities of ₩38.6b due within a year, and liabilities of ₩68.2b falling due after that. Offsetting this, it had ₩23.6b in cash and ₩25.3b in receivables that were due within 12 months. So it has liabilities totalling ₩57.9b more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of ₩74.2b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Samhwa Crown & Closure's net debt is 3.0 times its EBITDA, which is a significant but still reasonable amount of leverage. However, its interest coverage of 17.9 is very high, suggesting that the interest expense on the debt is currently quite low. Unfortunately, Samhwa Crown & Closure saw its EBIT slide 7.5% in the last twelve months. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. There's no doubt that we learn most about debt from the balance sheet. But it is Samhwa Crown & Closure's earnings that will influence how the balance sheet holds up in the future. 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last two years, Samhwa Crown & Closure barely recorded positive free cash flow, in total. While many companies do operate at break-even, we prefer see substantial free cash flow, especially if a it already has dead.

Our View

We'd go so far as to say Samhwa Crown & Closure's conversion of EBIT to free cash flow was disappointing. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Samhwa Crown & Closure stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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. Case in point: We've spotted 6 warning signs for Samhwa Crown & Closure 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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