POSCO Holdings (KRX:005490) Has A Somewhat Strained Balance Sheet

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that POSCO Holdings Inc. (KRX:005490) does use debt in its business. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth 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 POSCO Holdings

What Is POSCO Holdings's Debt?

As you can see below, POSCO Holdings had ₩29t of debt, at June 2024, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has ₩19t in cash leading to net debt of about ₩9.75t.

How Healthy Is POSCO Holdings' Balance Sheet?

We can see from the most recent balance sheet that POSCO Holdings had liabilities of ₩23t falling due within a year, and liabilities of ₩21t due beyond that. Offsetting these obligations, it had cash of ₩19t as well as receivables valued at ₩13t due within 12 months. So its liabilities total ₩12t more than the combination of its cash and short-term receivables.

POSCO Holdings has a very large market capitalization of ₩27t, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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).

POSCO Holdings has net debt worth 1.5 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 6.4 times the interest expense. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. The good news is that POSCO Holdings has increased its EBIT by 2.0% over twelve months, which should ease any concerns about debt repayment. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if POSCO Holdings can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. In the last three years, POSCO Holdings created free cash flow amounting to 4.0% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

POSCO Holdings's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. For example, its net debt to EBITDA is relatively strong. Taking the abovementioned factors together we do think POSCO Holdings's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. 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. For instance, we've identified 1 warning sign for POSCO Holdings that you should be aware of.

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. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.