Is Hyosung Advanced Materials (KRX:298050) 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. We can see that Hyosung Advanced Materials Corporation (KRX:298050) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. 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. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Hyosung Advanced Materials

What Is Hyosung Advanced Materials's Debt?

The image below, which you can click on for greater detail, shows that at June 2020 Hyosung Advanced Materials had debt of ₩1.86t, up from ₩1.72t in one year. However, it also had ₩71.2b in cash, and so its net debt is ₩1.79t.

How Strong Is Hyosung Advanced Materials's Balance Sheet?

We can see from the most recent balance sheet that Hyosung Advanced Materials had liabilities of ₩1.76t falling due within a year, and liabilities of ₩332.3b due beyond that. Offsetting this, it had ₩71.2b in cash and ₩337.5b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₩1.68t.

The deficiency here weighs heavily on the ₩647.9b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. After all, Hyosung Advanced Materials would likely require a major re-capitalisation if it had to pay its creditors today.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Weak interest cover of 0.75 times and a disturbingly high net debt to EBITDA ratio of 8.2 hit our confidence in Hyosung Advanced Materials like a one-two punch to the gut. The debt burden here is substantial. Even worse, Hyosung Advanced Materials saw its EBIT tank 75% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Hyosung Advanced Materials's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last two years, Hyosung Advanced Materials saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both Hyosung Advanced Materials's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. And even its interest cover fails to inspire much confidence. Considering everything we've mentioned above, it's fair to say that Hyosung Advanced Materials is carrying heavy debt load. If you harvest honey without a bee suit, you risk getting stung, so we'd probably stay away from this particular stock. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 1 warning sign for Hyosung Advanced Materials 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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