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 note that Sungchang Enterprise Holdings Limited (KRX:000180) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
Generally speaking, debt only becomes a real problem when a company can’t easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company’s debt levels is to consider its cash and debt together.
How Much Debt Does Sungchang Enterprise Holdings Carry?
You can click the graphic below for the historical numbers, but it shows that Sungchang Enterprise Holdings had ₩78.3b of debt in December 2020, down from ₩82.5b, one year before. However, because it has a cash reserve of ₩19.3b, its net debt is less, at about ₩59.0b.
How Strong Is Sungchang Enterprise Holdings’ Balance Sheet?
We can see from the most recent balance sheet that Sungchang Enterprise Holdings had liabilities of ₩88.8b falling due within a year, and liabilities of ₩85.6b due beyond that. Offsetting these obligations, it had cash of ₩19.3b as well as receivables valued at ₩32.5b due within 12 months. So its liabilities total ₩122.7b more than the combination of its cash and short-term receivables.
This is a mountain of leverage relative to its market capitalization of ₩150.4b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
In order to size up a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its 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).
Sungchang Enterprise Holdings has a debt to EBITDA ratio of 3.3 and its EBIT covered its interest expense 3.8 times. Taken together this implies that, while we wouldn’t want to see debt levels rise, we think it can handle its current leverage. However, the silver lining was that Sungchang Enterprise Holdings achieved a positive EBIT of ₩8.0b in the last twelve months, an improvement on the prior year’s loss. When analysing debt levels, the balance sheet is the obvious place to start. But you can’t view debt in total isolation; since Sungchang Enterprise Holdings 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 it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Sungchang Enterprise Holdings recorded free cash flow worth a fulsome 82% of its EBIT, which is stronger than we’d usually expect. That positions it well to pay down debt if desirable to do so.
Neither Sungchang Enterprise Holdings’s ability to handle its total liabilities nor its net debt to EBITDA gave us confidence in its ability to take on more debt. But the good news is it seems to be able to convert EBIT to free cash flow with ease. Looking at all the angles mentioned above, it does seem to us that Sungchang Enterprise Holdings is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. 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. For example, we’ve discovered 1 warning sign for Sungchang Enterprise Holdings that you should be aware of before investing here.
At the end of the day, it’s often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It’s free.
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