Stock Analysis

KSS Line (KRX:044450) Takes On Some Risk With Its Use Of Debt

KOSE:A044450
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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 can see that KSS Line Ltd. (KRX:044450) does use debt in its business. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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.

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What Is KSS Line's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 KSS Line had ₩141.7b of debt, an increase on ₩62.9b, over one year. On the flip side, it has ₩37.0b in cash leading to net debt of about ₩104.7b.

debt-equity-history-analysis
KOSE:A044450 Debt to Equity History March 7th 2021

How Strong Is KSS Line's Balance Sheet?

We can see from the most recent balance sheet that KSS Line had liabilities of ₩155.6b falling due within a year, and liabilities of ₩560.0b due beyond that. On the other hand, it had cash of ₩37.0b and ₩10.1b worth of receivables due within a year. So it has liabilities totalling ₩668.4b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the ₩250.4b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. After all, KSS Line would likely require a major re-capitalisation if it had to pay its creditors today.

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). 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).

Looking at its net debt to EBITDA of 1.1 and interest cover of 2.9 times, it seems to us that KSS Line is probably using debt in a pretty reasonable way. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. If KSS Line can keep growing EBIT at last year's rate of 10% over the last year, then it will find its debt load easier to manage. The balance sheet is clearly the area to focus on when you are analysing debt. But it is KSS Line'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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, KSS Line recorded free cash flow worth a fulsome 99% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Our View

Neither KSS Line's ability to handle its total liabilities nor its interest cover gave us confidence in its ability to take on more debt. But the good news is it seems to be able to convert EBIT to free cash flow with ease. When we consider all the factors discussed, it seems to us that KSS Line is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. 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. For example, we've discovered 1 warning sign for KSS Line that you should be aware of before investing here.

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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