We Think SeAH SPECIALSTEEL (KRX:019440) Is Taking Some Risk With Its Debt

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.' 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 note that SeAH SPECIALSTEEL CO., LTD. (KRX:019440) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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 SeAH SPECIALSTEEL

How Much Debt Does SeAH SPECIALSTEEL Carry?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 SeAH SPECIALSTEEL had ₩155.3b of debt, an increase on ₩147.3b, over one year. However, it also had ₩30.5b in cash, and so its net debt is ₩124.8b.

How Healthy Is SeAH SPECIALSTEEL's Balance Sheet?

According to the last reported balance sheet, SeAH SPECIALSTEEL had liabilities of ₩189.9b due within 12 months, and liabilities of ₩50.0b due beyond 12 months. Offsetting these obligations, it had cash of ₩30.5b as well as receivables valued at ₩194.9b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₩14.5b.

Since publicly traded SeAH SPECIALSTEEL shares are worth a total of ₩99.9b, 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.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While SeAH SPECIALSTEEL's debt to EBITDA ratio (4.2) suggests that it uses some debt, its interest cover is very weak, at 0.71, suggesting high leverage. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Even worse, SeAH SPECIALSTEEL saw its EBIT tank 75% over the last 12 months. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that 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 SeAH SPECIALSTEEL 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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Happily for any shareholders, SeAH SPECIALSTEEL actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

SeAH SPECIALSTEEL's EBIT growth rate and interest cover definitely weigh on it, in our esteem. But its conversion of EBIT to free cash flow tells a very different story, and suggests some resilience. Looking at all the angles mentioned above, it does seem to us that SeAH SPECIALSTEEL is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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 SeAH SPECIALSTEEL is showing 4 warning signs in our investment analysis , and 2 of those are a bit unpleasant...

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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