Here's Why Youngbo Chemical (KRX:014440) Can Manage Its Debt Responsibly

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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Youngbo Chemical Co., Ltd. (KRX:014440) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. 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 Youngbo Chemical

How Much Debt Does Youngbo Chemical Carry?

As you can see below, at the end of September 2020, Youngbo Chemical had ₩13.2b of debt, up from ₩10.6b a year ago. Click the image for more detail. However, it does have ₩32.3b in cash offsetting this, leading to net cash of ₩19.1b.

How Healthy Is Youngbo Chemical's Balance Sheet?

The latest balance sheet data shows that Youngbo Chemical had liabilities of ₩30.7b due within a year, and liabilities of ₩2.02b falling due after that. On the other hand, it had cash of ₩32.3b and ₩25.5b worth of receivables due within a year. So it can boast ₩25.0b more liquid assets than total liabilities.

This surplus liquidity suggests that Youngbo Chemical's balance sheet could take a hit just as well as Homer Simpson's head can take a punch. On this view, lenders should feel as safe as the beloved of a black-belt karate master. Succinctly put, Youngbo Chemical boasts net cash, so it's fair to say it does not have a heavy debt load!

In fact Youngbo Chemical's saving grace is its low debt levels, because its EBIT has tanked 49% in the last twelve months. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. 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 Youngbo Chemical 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. While Youngbo Chemical has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last three years, Youngbo Chemical reported free cash flow worth 7.5% 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 it is always sensible to investigate a company's debt, in this case Youngbo Chemical has ₩19.1b in net cash and a decent-looking balance sheet. So we don't have any problem with Youngbo Chemical's use of debt. 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. Be aware that Youngbo Chemical is showing 4 warning signs in our investment analysis , and 1 of those is a bit unpleasant...

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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