We Think Daesung Energy (KRX:117580) Is Taking Some Risk With Its Debt

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 can see that Daesung Energy Co., Ltd. (KRX:117580) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Daesung Energy

What Is Daesung Energy's Net Debt?

As you can see below, at the end of December 2020, Daesung Energy had ₩96.4b of debt, up from ₩83.4b a year ago. Click the image for more detail. On the flip side, it has ₩43.3b in cash leading to net debt of about ₩53.1b.

How Healthy Is Daesung Energy's Balance Sheet?

According to the last reported balance sheet, Daesung Energy had liabilities of ₩277.6b due within 12 months, and liabilities of ₩110.2b due beyond 12 months. On the other hand, it had cash of ₩43.3b and ₩158.3b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₩186.1b.

When you consider that this deficiency exceeds the company's ₩156.8b market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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).

With net debt sitting at just 1.1 times EBITDA, Daesung Energy is arguably pretty conservatively geared. And it boasts interest cover of 9.8 times, which is more than adequate. The good news is that Daesung Energy has increased its EBIT by 6.6% over twelve months, which should ease any concerns about debt repayment. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Daesung Energy 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. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Daesung Energy reported free cash flow worth 10% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

Both Daesung Energy's level of total liabilities and its conversion of EBIT to free cash flow were discouraging. But on the brighter side of life, its interest cover leaves us feeling more frolicsome. We should also note that Gas Utilities industry companies like Daesung Energy commonly do use debt without problems. When we consider all the factors discussed, it seems to us that Daesung Energy is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. Be aware that Daesung Energy is showing 2 warning signs in our investment analysis , and 1 of those is a bit unpleasant...

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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