Is ATON (KOSDAQ:158430) Using Too Much Debt?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that ATON Inc. (KOSDAQ:158430) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for ATON

What Is ATON's Debt?

The image below, which you can click on for greater detail, shows that ATON had debt of ₩2.75b at the end of September 2020, a reduction from ₩4.40b over a year. However, it does have ₩41.1b in cash offsetting this, leading to net cash of ₩38.4b.

How Healthy Is ATON's Balance Sheet?

The latest balance sheet data shows that ATON had liabilities of ₩3.17b due within a year, and liabilities of ₩3.68b falling due after that. Offsetting these obligations, it had cash of ₩41.1b as well as receivables valued at ₩4.08b due within 12 months. So it can boast ₩38.3b more liquid assets than total liabilities.

This surplus strongly suggests that ATON has a rock-solid balance sheet (and the debt is of no concern whatsoever). On this view, lenders should feel as safe as the beloved of a black-belt karate master. Simply put, the fact that ATON has more cash than debt is arguably a good indication that it can manage its debt safely.

The modesty of its debt load may become crucial for ATON if management cannot prevent a repeat of the 40% cut to EBIT over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since ATON 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. While ATON 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. In the last two years, ATON's free cash flow amounted to 41% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Summing up

While it is always sensible to investigate a company's debt, in this case ATON has ₩38.4b in net cash and a decent-looking balance sheet. So we are not troubled with ATON's debt use. 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. To that end, you should learn about the 2 warning signs we've spotted with ATON (including 1 which can't be ignored) .

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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