We Think SK D&D (KRX:210980) Is Taking Some Risk With Its Debt

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies SK D&D Co. Ltd. (KRX:210980) makes use of debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, plenty of companies use debt to fund growth, without any negative consequences. 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 SK D&D

What Is SK D&D's Net Debt?

As you can see below, at the end of September 2020, SK D&D had ₩972.2b of debt, up from ₩844.7b a year ago. Click the image for more detail. However, it does have ₩279.4b in cash offsetting this, leading to net debt of about ₩692.8b.

How Strong Is SK D&D's Balance Sheet?

According to the last reported balance sheet, SK D&D had liabilities of ₩630.0b due within 12 months, and liabilities of ₩498.4b due beyond 12 months. On the other hand, it had cash of ₩279.4b and ₩71.1b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₩777.9b.

When you consider that this deficiency exceeds the company's ₩660.8b market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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.

SK D&D has net debt to EBITDA of 3.3 suggesting it uses a fair bit of leverage to boost returns. But the high interest coverage of 9.6 suggests it can easily service that debt. Notably, SK D&D's EBIT launched higher than Elon Musk, gaining a whopping 309% on last year. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if SK D&D can strengthen its balance sheet over time. 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, SK D&D saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

We'd go so far as to say SK D&D's conversion of EBIT to free cash flow was disappointing. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making SK D&D stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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. To that end, you should learn about the 4 warning signs we've spotted with SK D&D (including 2 which don't sit too well with us) .

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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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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