Charm EngineeringLtd (KRX:009310) Takes On Some Risk With Its Use Of Debt

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. Importantly, Charm Engineering Co.,Ltd. (KRX:009310) does carry debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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 Charm EngineeringLtd

How Much Debt Does Charm EngineeringLtd Carry?

The image below, which you can click on for greater detail, shows that Charm EngineeringLtd had debt of ₩36.0b at the end of September 2020, a reduction from ₩49.3b over a year. However, its balance sheet shows it holds ₩74.9b in cash, so it actually has ₩38.9b net cash.

How Strong Is Charm EngineeringLtd's Balance Sheet?

We can see from the most recent balance sheet that Charm EngineeringLtd had liabilities of ₩95.3b falling due within a year, and liabilities of ₩554.8b due beyond that. Offsetting these obligations, it had cash of ₩74.9b as well as receivables valued at ₩16.4b due within 12 months. So it has liabilities totalling ₩558.8b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the ₩93.2b 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. At the end of the day, Charm EngineeringLtd would probably need a major re-capitalization if its creditors were to demand repayment. Charm EngineeringLtd boasts net cash, so it's fair to say it does not have a heavy debt load, even if it does have very significant liabilities, in total.

It was also good to see that despite losing money on the EBIT line last year, Charm EngineeringLtd turned things around in the last 12 months, delivering and EBIT of ₩2.6b. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Charm EngineeringLtd 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. Charm EngineeringLtd may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last year, Charm EngineeringLtd 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.

Summing up

While Charm EngineeringLtd does have more liabilities than liquid assets, it also has net cash of ₩38.9b. Despite its cash we think that Charm EngineeringLtd seems to struggle to handle its total liabilities, so we are wary of the stock. 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. Case in point: We've spotted 4 warning signs for Charm EngineeringLtd you should be aware of, and 1 of them shouldn't be ignored.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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