Does Daewon Pharmaceutical (KRX:003220) Have A Healthy Balance Sheet?

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Daewon Pharmaceutical Co., Ltd. (KRX:003220) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Daewon Pharmaceutical

What Is Daewon Pharmaceutical's Net Debt?

The chart below, which you can click on for greater detail, shows that Daewon Pharmaceutical had ₩50.0b in debt in December 2020; about the same as the year before. However, it also had ₩10.5b in cash, and so its net debt is ₩39.5b.

How Strong Is Daewon Pharmaceutical's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Daewon Pharmaceutical had liabilities of ₩56.0b due within 12 months and liabilities of ₩66.4b due beyond that. Offsetting these obligations, it had cash of ₩10.5b as well as receivables valued at ₩42.3b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₩69.6b.

Daewon Pharmaceutical has a market capitalization of ₩339.0b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Daewon Pharmaceutical's net debt is only 1.00 times its EBITDA. And its EBIT easily covers its interest expense, being 26.6 times the size. So we're pretty relaxed about its super-conservative use of debt. It is just as well that Daewon Pharmaceutical's load is not too heavy, because its EBIT was down 31% over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Daewon Pharmaceutical'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.

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. In the last three years, Daewon Pharmaceutical basically broke even on a free cash flow basis. Some might say that's a concern, when it comes considering how easily it would be for it to down debt.

Our View

Neither Daewon Pharmaceutical's ability to grow its EBIT nor its conversion of EBIT to free cash flow gave us confidence in its ability to take on more debt. But its interest cover tells a very different story, and suggests some resilience. Taking the abovementioned factors together we do think Daewon Pharmaceutical's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. We've identified 1 warning sign with Daewon Pharmaceutical , and understanding them should be part of your investment process.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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