Is GaeaSoft (KOSDAQ:051160) Using Too Much 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 GaeaSoft Corp. (KOSDAQ:051160) makes use of debt. But is this debt a concern to shareholders?

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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for GaeaSoft

How Much Debt Does GaeaSoft Carry?

You can click the graphic below for the historical numbers, but it shows that as of December 2020 GaeaSoft had ₩28.8b of debt, an increase on none, over one year. However, its balance sheet shows it holds ₩61.7b in cash, so it actually has ₩32.9b net cash.

A Look At GaeaSoft's Liabilities

The latest balance sheet data shows that GaeaSoft had liabilities of ₩42.5b due within a year, and liabilities of ₩41.7b falling due after that. On the other hand, it had cash of ₩61.7b and ₩13.2b worth of receivables due within a year. So it has liabilities totalling ₩9.24b more than its cash and near-term receivables, combined.

Given GaeaSoft has a market capitalization of ₩343.1b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. Despite its noteworthy liabilities, GaeaSoft boasts net cash, so it's fair to say it does not have a heavy debt load!

Although GaeaSoft made a loss at the EBIT level, last year, it was also good to see that it generated ₩10.0b in EBIT over the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since GaeaSoft 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While GaeaSoft 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. Happily for any shareholders, GaeaSoft actually produced more free cash flow than EBIT over the last year. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Summing up

While it is always sensible to look at a company's total liabilities, it is very reassuring that GaeaSoft has ₩32.9b in net cash. And it impressed us with free cash flow of ₩22b, being 224% of its EBIT. So we don't think GaeaSoft'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. Be aware that GaeaSoft is showing 3 warning signs in our investment analysis , you should know about...

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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