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 Youlchon Chemical Co.,Ltd. (KRX:008730) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
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. 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 think about a company's use of debt, we first look at cash and debt together.
What Is Youlchon ChemicalLtd's Net Debt?
You can click the graphic below for the historical numbers, but it shows that Youlchon ChemicalLtd had ₩150.8b of debt in December 2020, down from ₩162.8b, one year before. However, because it has a cash reserve of ₩33.2b, its net debt is less, at about ₩117.7b.
How Healthy Is Youlchon ChemicalLtd's Balance Sheet?
According to the last reported balance sheet, Youlchon ChemicalLtd had liabilities of ₩159.8b due within 12 months, and liabilities of ₩105.9b due beyond 12 months. Offsetting this, it had ₩33.2b in cash and ₩124.3b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₩108.2b.
Youlchon ChemicalLtd has a market capitalization of ₩482.4b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (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).
We'd say that Youlchon ChemicalLtd's moderate net debt to EBITDA ratio ( being 2.2), indicates prudence when it comes to debt. And its commanding EBIT of 11.2 times its interest expense, implies the debt load is as light as a peacock feather. Youlchon ChemicalLtd grew its EBIT by 3.2% in the last year. Whilst that hardly knocks our socks off it is a positive when it comes to debt. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Youlchon ChemicalLtd 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Youlchon ChemicalLtd's free cash flow amounted to 28% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
When it comes to the balance sheet, the standout positive for Youlchon ChemicalLtd was the fact that it seems able to cover its interest expense with its EBIT confidently. But the other factors we noted above weren't so encouraging. For example, its conversion of EBIT to free cash flow makes us a little nervous about its debt. Looking at all this data makes us feel a little cautious about Youlchon ChemicalLtd's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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. For example - Youlchon ChemicalLtd has 2 warning signs we think 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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