Cosmo Chemical (KRX:005420) Has A Somewhat Strained Balance Sheet

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Cosmo Chemical Co., Ltd. (KRX:005420) does use debt in its business. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Cosmo Chemical

What Is Cosmo Chemical's Net Debt?

As you can see below, at the end of December 2020, Cosmo Chemical had ₩237.8b of debt, up from ₩190.6b a year ago. Click the image for more detail. However, it also had ₩25.4b in cash, and so its net debt is ₩212.4b.

How Healthy Is Cosmo Chemical's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Cosmo Chemical had liabilities of ₩264.0b due within 12 months and liabilities of ₩154.5b due beyond that. Offsetting these obligations, it had cash of ₩25.4b as well as receivables valued at ₩67.8b due within 12 months. So it has liabilities totalling ₩325.3b more than its cash and near-term receivables, combined.

When you consider that this deficiency exceeds the company's ₩308.1b market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). 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).

Cosmo Chemical shareholders face the double whammy of a high net debt to EBITDA ratio (7.8), and fairly weak interest coverage, since EBIT is just 0.62 times the interest expense. This means we'd consider it to have a heavy debt load. However, the silver lining was that Cosmo Chemical achieved a positive EBIT of ₩4.9b in the last twelve months, an improvement on the prior year's loss. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Cosmo Chemical will need earnings to service that debt. 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. During the last year, Cosmo Chemical burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both Cosmo Chemical's interest cover and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But at least its EBIT growth rate is not so bad. After considering the datapoints discussed, we think Cosmo Chemical has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 3 warning signs with Cosmo Chemical (at least 1 which shouldn't be ignored) , and understanding them should be part of your investment process.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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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