Korea Petrochemical Ind (KRX:006650) Seems To Use Debt Quite Sensibly

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.' 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. Importantly, Korea Petrochemical Ind. Co., Ltd. (KRX:006650) does carry debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Korea Petrochemical Ind

What Is Korea Petrochemical Ind's Debt?

As you can see below, Korea Petrochemical Ind had ₩46.6b of debt at September 2020, down from ₩56.0b a year prior. However, it does have ₩211.3b in cash offsetting this, leading to net cash of ₩164.7b.

A Look At Korea Petrochemical Ind's Liabilities

We can see from the most recent balance sheet that Korea Petrochemical Ind had liabilities of ₩85.3b falling due within a year, and liabilities of ₩159.3b due beyond that. Offsetting this, it had ₩211.3b in cash and ₩196.7b in receivables that were due within 12 months. So it actually has ₩163.4b more liquid assets than total liabilities.

This surplus suggests that Korea Petrochemical Ind has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Succinctly put, Korea Petrochemical Ind boasts net cash, so it's fair to say it does not have a heavy debt load!

But the bad news is that Korea Petrochemical Ind has seen its EBIT plunge 18% in the last twelve months. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Korea Petrochemical Ind 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. Korea Petrochemical Ind 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. Over the most recent three years, Korea Petrochemical Ind recorded free cash flow worth 73% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that Korea Petrochemical Ind has net cash of ₩164.7b, as well as more liquid assets than liabilities. The cherry on top was that in converted 73% of that EBIT to free cash flow, bringing in ₩153b. So we are not troubled with Korea Petrochemical Ind's debt use. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Consider for instance, the ever-present spectre of investment risk. We've identified 2 warning signs with Korea Petrochemical Ind , and understanding them should be part of your investment process.

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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