Is POSCO (KRX:005490) Using Too Much Debt?

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.' 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 note that POSCO (KRX:005490) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for POSCO

What Is POSCO's Debt?

The chart below, which you can click on for greater detail, shows that POSCO had ₩20t in debt in December 2020; about the same as the year before. On the flip side, it has ₩16t in cash leading to net debt of about ₩3.25t.

How Strong Is POSCO's Balance Sheet?

According to the last reported balance sheet, POSCO had liabilities of ₩17t due within 12 months, and liabilities of ₩15t due beyond 12 months. Offsetting this, it had ₩16t in cash and ₩9.66t in receivables that were due within 12 months. So its liabilities total ₩5.28t more than the combination of its cash and short-term receivables.

This deficit isn't so bad because POSCO is worth a massive ₩24t, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

POSCO has a low net debt to EBITDA ratio of only 0.54. And its EBIT covers its interest expense a whopping 11.2 times over. So we're pretty relaxed about its super-conservative use of debt. The modesty of its debt load may become crucial for POSCO if management cannot prevent a repeat of the 36% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine POSCO'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. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, POSCO actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

Based on what we've seen POSCO is not finding it easy, given its EBIT growth rate, but the other factors we considered give us cause to be optimistic. In particular, we are dazzled with its conversion of EBIT to free cash flow. Considering this range of data points, we think POSCO is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. 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. For instance, we've identified 3 warning signs for POSCO that you should be aware of.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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