We Think Kyung Dong Pharmaceutical (KOSDAQ:011040) Can Manage Its Debt With Ease

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 Kyung Dong Pharmaceutical Co., Ltd. (KOSDAQ:011040) does use debt in its business. 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. 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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Kyung Dong Pharmaceutical

What Is Kyung Dong Pharmaceutical's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Kyung Dong Pharmaceutical had ₩8.20b of debt in September 2020, down from ₩19.6b, one year before. But on the other hand it also has ₩94.5b in cash, leading to a ₩86.3b net cash position.

How Healthy Is Kyung Dong Pharmaceutical's Balance Sheet?

The latest balance sheet data shows that Kyung Dong Pharmaceutical had liabilities of ₩25.4b due within a year, and liabilities of ₩10.6b falling due after that. Offsetting this, it had ₩94.5b in cash and ₩15.8b in receivables that were due within 12 months. So it actually has ₩74.4b more liquid assets than total liabilities.

This surplus suggests that Kyung Dong Pharmaceutical is using debt in a way that is appears to be both safe and conservative. Because it has plenty of assets, it is unlikely to have trouble with its lenders. Succinctly put, Kyung Dong Pharmaceutical boasts net cash, so it's fair to say it does not have a heavy debt load!

On top of that, Kyung Dong Pharmaceutical grew its EBIT by 40% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is Kyung Dong Pharmaceutical's earnings that will influence how the balance sheet holds up in the future. 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. While Kyung Dong Pharmaceutical 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 most recent three years, Kyung Dong Pharmaceutical recorded free cash flow worth 63% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that Kyung Dong Pharmaceutical has net cash of ₩86.3b, as well as more liquid assets than liabilities. And we liked the look of last year's 40% year-on-year EBIT growth. So we don't think Kyung Dong Pharmaceutical's use of debt is risky. 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. Case in point: We've spotted 3 warning signs for Kyung Dong Pharmaceutical you should be aware of, and 1 of them shouldn't be ignored.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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