Incon (KOSDAQ:083640) Takes On Some Risk With Its Use Of Debt

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.' 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 can see that Incon Co., Ltd. (KOSDAQ:083640) does use debt in its business. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Incon

What Is Incon's Debt?

As you can see below, Incon had ₩27.1b of debt, at September 2020, which is about the same as the year before. You can click the chart for greater detail. However, because it has a cash reserve of ₩25.9b, its net debt is less, at about ₩1.27b.

How Healthy Is Incon's Balance Sheet?

According to the last reported balance sheet, Incon had liabilities of ₩39.0b due within 12 months, and liabilities of ₩1.18b due beyond 12 months. Offsetting these obligations, it had cash of ₩25.9b as well as receivables valued at ₩7.66b due within 12 months. So its liabilities total ₩6.68b more than the combination of its cash and short-term receivables.

Given Incon has a market capitalization of ₩139.2b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. But either way, Incon has virtually no net debt, so it's fair to say it does not have a heavy debt load!

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Given net debt is only 1.0 times EBITDA, it is initially surprising to see that Incon's EBIT has low interest coverage of 0.13 times. So one way or the other, it's clear the debt levels are not trivial. We also note that Incon improved its EBIT from a last year's loss to a positive ₩213m. When analysing debt levels, the balance sheet is the obvious place to start. But it is Incon's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Incon saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

While Incon's interest cover makes us cautious about it, its track record of converting EBIT to free cash flow is no better. At least its net debt to EBITDA gives us reason to be optimistic. When we consider all the factors discussed, it seems to us that Incon is taking some risks with its use of debt. 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. Consider for instance, the ever-present spectre of investment risk. We've identified 3 warning signs with Incon (at least 1 which is concerning) , 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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