Is Green Chemical (KRX:083420) Using Too Much 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.' 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. As with many other companies Green Chemical Co., Ltd. (KRX:083420) makes use of debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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.

View our latest analysis for Green Chemical

How Much Debt Does Green Chemical Carry?

You can click the graphic below for the historical numbers, but it shows that Green Chemical had ₩28.4b of debt in September 2020, down from ₩41.5b, one year before. However, it does have ₩26.5b in cash offsetting this, leading to net debt of about ₩1.86b.

A Look At Green Chemical's Liabilities

According to the last reported balance sheet, Green Chemical had liabilities of ₩52.2b due within 12 months, and liabilities of ₩12.4b due beyond 12 months. Offsetting this, it had ₩26.5b in cash and ₩32.5b in receivables that were due within 12 months. So it has liabilities totalling ₩5.56b more than its cash and near-term receivables, combined.

This state of affairs indicates that Green Chemical's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So while it's hard to imagine that the ₩302.4b company is struggling for cash, we still think it's worth monitoring its balance sheet. Carrying virtually no net debt, Green Chemical has a very light debt load indeed.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its 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).

Green Chemical has very little debt (net of cash), and boasts a debt to EBITDA ratio of 0.06 and EBIT of 32.4 times the interest expense. So relative to past earnings, the debt load seems trivial. Better yet, Green Chemical grew its EBIT by 196% last year, which is an impressive improvement. If maintained that growth will make the debt even more manageable in the years ahead. 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 Green Chemical will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. Happily for any shareholders, Green Chemical actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

Green Chemical's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And that's just the beginning of the good news since its conversion of EBIT to free cash flow is also very heartening. We think Green Chemical is no more beholden to its lenders, than the birds are to birdwatchers. To our minds it has a healthy happy balance sheet. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 1 warning sign for Green Chemical that you should be aware of.

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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