Is Korea District Heating (KRX:071320) 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 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. Importantly, Korea District Heating Corp. (KRX:071320) does carry debt. But is this debt a concern to shareholders?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Korea District Heating

What Is Korea District Heating's Net Debt?

The image below, which you can click on for greater detail, shows that Korea District Heating had debt of ₩2.75t at the end of December 2020, a reduction from ₩2.93t over a year. Net debt is about the same, since the it doesn't have much cash.

A Look At Korea District Heating's Liabilities

We can see from the most recent balance sheet that Korea District Heating had liabilities of ₩920.9b falling due within a year, and liabilities of ₩3.35t due beyond that. On the other hand, it had cash of ₩31.8b and ₩476.8b worth of receivables due within a year. So its liabilities total ₩3.76t more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the ₩487.5b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Korea District Heating would likely require a major re-capitalisation if it had to pay its creditors today.

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).

Korea District Heating shareholders face the double whammy of a high net debt to EBITDA ratio (7.1), and fairly weak interest coverage, since EBIT is just 2.4 times the interest expense. This means we'd consider it to have a heavy debt load. However, it should be some comfort for shareholders to recall that Korea District Heating actually grew its EBIT by a hefty 207%, over the last 12 months. If it can keep walking that path it will be in a position to shed its debt with relative ease. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Korea District Heating will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Korea District Heating burned a lot of cash. 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.

Our View

To be frank both Korea District Heating's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it's pretty decent at growing its EBIT; that's encouraging. It's also worth noting that Korea District Heating is in the Electric Utilities industry, which is often considered to be quite defensive. Overall, it seems to us that Korea District Heating's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. To that end, you should learn about the 3 warning signs we've spotted with Korea District Heating (including 1 which is potentially serious) .

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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