We Think Lotte Chemical (KRX:011170) Is Taking Some Risk With Its 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. As with many other companies Lotte Chemical Corporation (KRX:011170) makes use of debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Lotte Chemical

What Is Lotte Chemical's 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 it also has ₩3.42t in cash to offset that, meaning it has ₩198.0b net cash.

A Look At Lotte Chemical's Liabilities

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. Offsetting this, it had ₩3.42t in cash and ₩148.4m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₩1.91t.

While this might seem like a lot, it is not so bad since Lotte Chemical has a market capitalization of ₩9.29t, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. 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.

Shareholders should be aware that Lotte Chemical's EBIT was down 73% last year. 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 it is future earnings, more than anything, that will determine Lotte Chemical's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. 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

Although Lotte Chemical's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of ₩198.0b. So while Lotte Chemical does not have a great balance sheet, it's certainly not too bad. 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. To that end, you should be aware of the 4 warning signs we've spotted with Lotte Chemical .

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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