Daewon Pharmaceutical (KRX:003220) Seems To Use Debt Quite Sensibly

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. As with many other companies Daewon Pharmaceutical Co., Ltd. (KRX:003220) makes use of debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. 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. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Daewon Pharmaceutical

What Is Daewon Pharmaceutical's Debt?

The image below, which you can click on for greater detail, shows that at September 2020 Daewon Pharmaceutical had debt of ₩50.0b, up from ₩47.0b in one year. However, it also had ₩19.4b in cash, and so its net debt is ₩30.6b.

How Healthy Is Daewon Pharmaceutical's Balance Sheet?

The latest balance sheet data shows that Daewon Pharmaceutical had liabilities of ₩56.7b due within a year, and liabilities of ₩67.8b falling due after that. On the other hand, it had cash of ₩19.4b and ₩44.0b worth of receivables due within a year. So it has liabilities totalling ₩61.0b more than its cash and near-term receivables, combined.

Since publicly traded Daewon Pharmaceutical shares are worth a total of ₩363.1b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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).

Daewon Pharmaceutical's net debt is only 0.65 times its EBITDA. And its EBIT covers its interest expense a whopping 43.5 times over. So we're pretty relaxed about its super-conservative use of debt. The good news is that Daewon Pharmaceutical has increased its EBIT by 2.9% over twelve months, which should ease any concerns about debt repayment. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Daewon Pharmaceutical 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Daewon Pharmaceutical recorded negative free cash flow, in total. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Our View

On our analysis Daewon Pharmaceutical's interest cover should signal that it won't have too much trouble with its debt. But the other factors we noted above weren't so encouraging. To be specific, it seems about as good at converting EBIT to free cash flow as wet socks are at keeping your feet warm. Looking at all this data makes us feel a little cautious about Daewon Pharmaceutical's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 1 warning sign for Daewon Pharmaceutical that you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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