Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that ‘Volatility is far from synonymous with risk’. 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 Samsung SDI Co., Ltd. (KRX:006400) makes use of debt. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. When we think about a company’s use of debt, we first look at cash and debt together.
What Is Samsung SDI’s Debt?
The image below, which you can click on for greater detail, shows that at September 2019 Samsung SDI had debt of ₩3.41t, up from ₩2.77m in one year. However, it does have ₩1.10t in cash offsetting this, leading to net debt of about ₩2.31t.
How Strong Is Samsung SDI’s Balance Sheet?
We can see from the most recent balance sheet that Samsung SDI had liabilities of ₩3.39t falling due within a year, and liabilities of ₩3.59t due beyond that. Offsetting these obligations, it had cash of ₩1.10t as well as receivables valued at ₩1.73t due within 12 months. So its liabilities total ₩4.15t more than the combination of its cash and short-term receivables.
This deficit isn’t so bad because Samsung SDI is worth a massive ₩19t, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
Samsung SDI’s net debt to EBITDA ratio of about 1.6 suggests only moderate use of debt. And its strong interest cover of 10.9 times, makes us even more comfortable. And we also note warmly that Samsung SDI grew its EBIT by 18% last year, making its debt load easier to handle. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Samsung SDI’s ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last two years, Samsung SDI saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
Based on what we’ve seen Samsung SDI is not finding it easy, given its conversion of EBIT to free cash flow, but the other factors we considered give us cause to be optimistic. In particular, we are dazzled with its interest cover. Looking at all this data makes us feel a little cautious about Samsung SDI’s debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. Over time, share prices tend to follow earnings per share, so if you’re interested in Samsung SDI, you may well want to click here to check an interactive graph of its earnings per share history.
If, after all that, you’re more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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