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.’ 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. Importantly, Daewon Kang Up Co., Ltd. (KRX:000430) does carry debt. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Daewon Kang Up Carry?
The image below, which you can click on for greater detail, shows that Daewon Kang Up had debt of ₩233.9b at the end of December 2020, a reduction from ₩251.1b over a year. However, because it has a cash reserve of ₩63.5b, its net debt is less, at about ₩170.4b.
A Look At Daewon Kang Up’s Liabilities
The latest balance sheet data shows that Daewon Kang Up had liabilities of ₩363.8b due within a year, and liabilities of ₩82.0b falling due after that. On the other hand, it had cash of ₩63.5b and ₩176.7b worth of receivables due within a year. So its liabilities total ₩205.5b more than the combination of its cash and short-term receivables.
This deficit is considerable relative to its market capitalization of ₩277.5b, so it does suggest shareholders should keep an eye on Daewon Kang Up’s use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.
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).
While we wouldn’t worry about Daewon Kang Up’s net debt to EBITDA ratio of 3.0, we think its super-low interest cover of 0.62 times is a sign of high leverage. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Even worse, Daewon Kang Up saw its EBIT tank 81% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. There’s no doubt that we learn most about debt from the balance sheet. But you can’t view debt in total isolation; since Daewon Kang Up 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 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. Over the last three years, Daewon Kang Up actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
On the face of it, Daewon Kang Up’s interest cover 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. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Once we consider all the factors above, together, it seems to us that Daewon Kang Up’s debt is making it a bit risky. That’s not necessarily a bad…