David Iben put it well when he said, ‘Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.’ It’s only natural to consider a company’s balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that Motrex Co., Ltd (KOSDAQ:118990) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company’s use of debt, we first look at cash and debt together.
What Is Motrex’s Net Debt?
As you can see below, Motrex had ₩161.3b of debt at December 2020, down from ₩194.6b a year prior. On the flip side, it has ₩40.7b in cash leading to net debt of about ₩120.6b.
A Look At Motrex’s Liabilities
According to the last reported balance sheet, Motrex had liabilities of ₩124.7b due within 12 months, and liabilities of ₩192.0b due beyond 12 months. Offsetting this, it had ₩40.7b in cash and ₩64.2b in receivables that were due within 12 months. So its liabilities total ₩211.8b more than the combination of its cash and short-term receivables.
Given this deficit is actually higher than the company’s market capitalization of ₩204.5b, we think shareholders really should watch Motrex’s debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
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 Motrex’s net debt to EBITDA ratio of 3.9, we think its super-low interest cover of 1.3 times is a sign of 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. One redeeming factor for Motrex is that it turned last year’s EBIT loss into a gain of ₩11b, over the last twelve months. There’s no doubt that we learn most about debt from the balance sheet. But you can’t view debt in total isolation; since Motrex 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. During the last year, Motrex produced sturdy free cash flow equating to 68% of its EBIT, about what we’d expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Mulling over Motrex’s attempt at covering its interest expense with its EBIT, we’re certainly not enthusiastic. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Motrex stock a bit risky. That’s not necessarily a bad thing, but we’d generally feel more comfortable with less leverage. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet – far from it. Case in point: We’ve spotted 3 warning signs for Motrex you should be aware of, and 1 of them is significant.
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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