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 Sangsin Brake Co., Ltd. (KRX:041650) does use debt in its business. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company’s debt levels is to consider its cash and debt together.
How Much Debt Does Sangsin Brake Carry?
As you can see below, Sangsin Brake had ₩188.0b of debt, at December 2020, which is about the same as the year before. You can click the chart for greater detail. However, it also had ₩46.6b in cash, and so its net debt is ₩141.5b.
A Look At Sangsin Brake’s Liabilities
We can see from the most recent balance sheet that Sangsin Brake had liabilities of ₩210.6b falling due within a year, and liabilities of ₩59.3b due beyond that. Offsetting this, it had ₩46.6b in cash and ₩94.9b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₩128.4b.
This deficit casts a shadow over the ₩82.3b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, Sangsin Brake would probably need a major re-capitalization if its creditors were to demand repayment.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
While Sangsin Brake’s debt to EBITDA ratio (4.7) suggests that it uses some debt, its interest cover is very weak, at 1.4, suggesting high leverage. In large part that’s due to the company’s significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Worse, Sangsin Brake’s EBIT was down 50% over the last year. If earnings keep going like that over the long term, it has a snowball’s chance in hell of paying off that debt. The balance sheet is clearly the area to focus on when you are analysing debt. But you can’t view debt in total isolation; since Sangsin Brake 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.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Sangsin Brake 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.
On the face of it, Sangsin Brake’s conversion of EBIT to free cash flow left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. And even its interest cover fails to inspire much confidence. It looks to us like Sangsin Brake carries a significant balance…