These 4 Measures Indicate That POSCO COATED & COLOR STEEL (KRX:058430) Is Using Debt Extensively

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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that POSCO COATED & COLOR STEEL Co., Ltd. (KRX:058430) does use debt in its business. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own 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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for POSCO COATED & COLOR STEEL

How Much Debt Does POSCO COATED & COLOR STEEL Carry?

As you can see below, POSCO COATED & COLOR STEEL had ₩120.4b of debt at September 2020, down from ₩145.4b a year prior. However, it also had ₩47.2b in cash, and so its net debt is ₩73.3b.

A Look At POSCO COATED & COLOR STEEL's Liabilities

According to the last reported balance sheet, POSCO COATED & COLOR STEEL had liabilities of ₩249.5b due within 12 months, and liabilities of ₩30.5b due beyond 12 months. Offsetting this, it had ₩47.2b in cash and ₩149.1b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₩83.8b.

POSCO COATED & COLOR STEEL has a market capitalization of ₩196.5b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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.

POSCO COATED & COLOR STEEL has net debt worth 2.2 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 3.8 times the interest expense. In large part that's due to the company's significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. POSCO COATED & COLOR STEEL grew its EBIT by 3.1% in the last year. Whilst that hardly knocks our socks off it is a positive when it comes to 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 POSCO COATED & COLOR STEEL 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, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, POSCO COATED & COLOR STEEL recorded free cash flow of 38% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

While POSCO COATED & COLOR STEEL's conversion of EBIT to free cash flow makes us cautious about it, its track record of covering its interest expense with its EBIT is no better. At least its EBIT growth rate gives us reason to be optimistic. We think that POSCO COATED & COLOR STEEL's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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 instance, we've identified 4 warning signs for POSCO COATED & COLOR STEEL (1 shouldn't be ignored) you should be aware of.

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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