Is Industrial Korea (KRX: 002140) Using Too Much Debt?
Legendary fund manager Li Lu (whom Charlie Munger supported) once said, “The biggest risk in investing is not price volatility, but whether you will suffer a permanent loss of capital.” . So it might be obvious that you need to factor in debt, when you think about how risky a given stock is because too much debt can sink a business. We can see that Korea Industrial Co., Ltd. (KRX: 002140) uses debt in his business. But the most important question is: what is the risk that this debt creates?
What risk does debt entail?
Debt helps a business until it struggles to pay it off, either with new capital or with free cash flow. If things really go wrong, lenders can take over the business. However, a more common (but still painful) scenario is that he has to raise new equity at low cost, thereby constantly diluting shareholders. That said, the most common situation is where a business manages its debt reasonably well – and to its advantage. The first thing to do when considering how much debt a business uses is to look at its cash flow and debt together.
Check out our latest analysis for Korea Industrial
What is the debt of the Korean industry?
As you can see below, at the end of December 2020, Korea Industrial was owed 81.6 billion in debt, up from £ 73.2 billion a year ago. Click on the image for more details. On the other hand, it has ₩ 17.1 billion in cash, which leads to a net debt of around ₩ 64.4 billion.
A look at the responsibilities of Korean industry
According to the latest published balance sheet, Korea Industrial had liabilities of $ 100.5 billion due within 12 months and liabilities of $ 13.4 billion beyond 12 months. In return, he has 17.1 billion euros in cash and 42.6 billion euros in receivables due within 12 months. It therefore has liabilities totaling ₩ 54.2 billion more than its cash and short-term receivables combined.
While this may sound like a lot, it’s not so bad since Korea Industrial has a market cap of ₩ 105.6 billion, and could therefore likely strengthen its balance sheet by raising capital if needed. However, it is always worth taking a close look at your ability to repay your debt.
We use two main ratios to tell us about leverage versus earnings levels. The first is net debt divided by earnings before interest, taxes, depreciation and amortization (EBITDA), while the second is the number of times its profit before interest and taxes (EBIT) covers its interest expense (or its coverage of interest, for short). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt over EBITDA) and the actual interest charges associated with that debt (with its interest coverage ratio).
While Korea Industrial’s debt-to-EBITDA ratio of 5.1 suggests heavy leverage, its interest coverage of 8.2 implies that it is servicing that debt with ease. Our best guess is that the company does have significant debt. It should be noted that Korea Industrial’s EBIT has soared like bamboo after the rain, gaining 63% in the past twelve months. This will make it easier to manage your debt. The balance sheet is clearly the area to focus on when analyzing debt. But you cannot view the debt in total isolation; since Korea Industrial will need revenue to service this debt. So when you consider debt, it’s really worth looking at the profit trend. Click here for an interactive snapshot.
Finally, a business can only pay off its debts with cash, not book profits. The logical step is therefore to examine the proportion of this EBIT that corresponds to the actual free cash flow. In the past three years, Korea Industrial has burned a lot of money. While this may be the result of spending for growth, it makes debt much riskier.
Our point of view
Korea Industrial’s conversion of EBIT to free cash flow and net debt to EBITDA is certainly weighing on it, in our view. But its EBIT growth rate tells a very different story and suggests some resilience. Looking at all of the angles mentioned above, it seems to us that Korea Industrial is a somewhat risky investment due to its debt. Not all risks are bad, as they can increase stock returns if they pay off, but this risk of leverage is worth considering. There is no doubt that we learn the most about debt from the balance sheet. But at the end of the day, every business can contain risks that exist off the balance sheet. For example, Korea Industrial has 5 warning signs (and 2 that can’t be ignored) we think you should know.
If you want to invest in companies that can generate profits without the burden of debt, take a look at this free list of growing companies that have net cash on the balance sheet.
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