Here's Why Hannong Chemicals (KRX:011500) Can Manage Its Debt Responsibly

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 Hannong Chemicals Inc. (KRX:011500) makes use of debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Hannong Chemicals

What Is Hannong Chemicals's Debt?

You can click the graphic below for the historical numbers, but it shows that Hannong Chemicals had ₩18.2b of debt in September 2020, down from ₩20.5b, one year before. However, it does have ₩5.90b in cash offsetting this, leading to net debt of about ₩12.3b.

How Strong Is Hannong Chemicals' Balance Sheet?

According to the last reported balance sheet, Hannong Chemicals had liabilities of ₩32.8b due within 12 months, and liabilities of ₩10.5b due beyond 12 months. Offsetting this, it had ₩5.90b in cash and ₩40.8b in receivables that were due within 12 months. So it can boast ₩3.38b more liquid assets than total liabilities.

This state of affairs indicates that Hannong Chemicals' balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So it's very unlikely that the ₩238.6b company is short on cash, but still worth keeping an eye on the balance sheet.

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).

Hannong Chemicals's net debt is only 0.59 times its EBITDA. And its EBIT covers its interest expense a whopping 30.4 times over. So we're pretty relaxed about its super-conservative use of debt. On top of that, Hannong Chemicals grew its EBIT by 44% over the last twelve months, and that growth will make it easier to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Hannong Chemicals will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Hannong Chemicals's free cash flow amounted to 21% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

The good news is that Hannong Chemicals's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But, on a more sombre note, we are a little concerned by its conversion of EBIT to free cash flow. Zooming out, Hannong Chemicals seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. 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 - Hannong Chemicals has 1 warning sign we think you should be aware of.

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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