Is Derkwoo Electronics (KOSDAQ:263600) 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 Derkwoo Electronics Co., Ltd (KOSDAQ:263600) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own 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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Derkwoo Electronics

What Is Derkwoo Electronics's Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Derkwoo Electronics had ₩35.7b of debt, an increase on ₩7.42b, over one year. But it also has ₩39.3b in cash to offset that, meaning it has ₩3.62b net cash.

How Strong Is Derkwoo Electronics's Balance Sheet?

The latest balance sheet data shows that Derkwoo Electronics had liabilities of ₩39.0b due within a year, and liabilities of ₩21.4b falling due after that. Offsetting this, it had ₩39.3b in cash and ₩21.1b in receivables that were due within 12 months. So its total liabilities are just about perfectly matched by its shorter-term, liquid assets.

This state of affairs indicates that Derkwoo Electronics's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So while it's hard to imagine that the ₩115.5b company is struggling for cash, we still think it's worth monitoring its balance sheet. While it does have liabilities worth noting, Derkwoo Electronics also has more cash than debt, so we're pretty confident it can manage its debt safely.

Even more impressive was the fact that Derkwoo Electronics grew its EBIT by 180% over twelve months. That boost will make it even easier to pay down debt going forward. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Derkwoo Electronics 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. Derkwoo Electronics 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 three years, Derkwoo Electronics 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.

Summing up

While it is always sensible to look at a company's total liabilities, it is very reassuring that Derkwoo Electronics has ₩3.62b in net cash. And we liked the look of last year's 180% year-on-year EBIT growth. So we don't have any problem with Derkwoo Electronics's use of debt. 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. Take risks, for example - Derkwoo Electronics has 3 warning signs (and 2 which are a bit unpleasant) we think you should know about.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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