Legendary fund manager Li Lu (who Charlie Munger backed) once said, ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital. So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that DIOSTECH Co.,Ltd (KOSDAQ:196450) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
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. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.
What Is DIOSTECHLtd’s Net Debt?
As you can see below, at the end of September 2019, DIOSTECHLtd had ₩23.1b of debt, up from ₩13.3b a year ago. Click the image for more detail. However, because it has a cash reserve of ₩1.94b, its net debt is less, at about ₩21.2b.
A Look At DIOSTECHLtd’s Liabilities
We can see from the most recent balance sheet that DIOSTECHLtd had liabilities of ₩32.7b falling due within a year, and liabilities of ₩9.54b due beyond that. Offsetting this, it had ₩1.94b in cash and ₩18.5b in receivables that were due within 12 months. So it has liabilities totalling ₩21.8b more than its cash and near-term receivables, combined.
DIOSTECHLtd has a market capitalization of ₩58.9b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
We measure a company’s debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
While DIOSTECHLtd has a quite reasonable net debt to EBITDA multiple of 2.2, its interest cover seems weak, at 0.78. In large part that’s it has so much depreciation and amortisation. These charges may be non-cash, so they could be excluded when it comes to paying down debt. But the accounting charges are there for a reason — some assets are seen to be losing value. Either way there’s no doubt the stock is using meaningful leverage. We also note that DIOSTECHLtd improved its EBIT from a last year’s loss to a positive ₩2.1b. There’s no doubt that we learn most about debt from the balance sheet. But it is DIOSTECHLtd’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, a company can only pay off debt with cold hard cash, not accounting profits. 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, DIOSTECHLtd actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
DIOSTECHLtd’s interest cover was a real negative on this analysis, although the other factors we considered were considerably better. In particular, we are dazzled with its conversion of EBIT to free cash flow. Looking at all this data makes us feel a little cautious about DIOSTECHLtd’s debt levels. While we appreciate debt can enhance returns on equity, we’d suggest that shareholders keep close watch on its debt levels, lest they increase. 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. Be aware that DIOSTECHLtd is showing 2 warning signs in our investment analysis , you should know about…
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.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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. Simply Wall St has no position in the stocks mentioned.
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