Does Lotte Chemical (KRX:011170) Have A Healthy 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.' 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 Lotte Chemical Corporation (KRX:011170) does use debt in its business. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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.

View our latest analysis for Lotte Chemical

What Is Lotte Chemical's Net Debt?

The image below, which you can click on for greater detail, shows that Lotte Chemical had debt of ₩3.22t at the end of September 2020, a reduction from ₩4.65t over a year. But on the other hand it also has ₩3.42t in cash, leading to a ₩198.0b net cash position.

How Strong Is Lotte Chemical's Balance Sheet?

We can see from the most recent balance sheet that Lotte Chemical had liabilities of ₩2.31t falling due within a year, and liabilities of ₩3.02t due beyond that. On the other hand, it had cash of ₩3.42t and ₩148.4m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₩1.91t.

Since publicly traded Lotte Chemical shares are worth a total of ₩10t, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. While it does have liabilities worth noting, Lotte Chemical also has more cash than debt, so we're pretty confident it can manage its debt safely.

Importantly, Lotte Chemical's EBIT fell a jaw-dropping 73% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Lotte Chemical 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 company can only pay off debt with cold hard cash, not accounting profits. Lotte Chemical 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 last three years, Lotte Chemical reported free cash flow worth 13% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Summing up

While Lotte Chemical does have more liabilities than liquid assets, it also has net cash of ₩198.0b. So while Lotte Chemical does not have a great balance sheet, it's certainly not too bad. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Be aware that Lotte Chemical is showing 3 warning signs in our investment analysis , you should know about...

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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