The external fund manager led by Charlie Munger from Berkshire Hathaway, Li Lu, makes no secret of it when he says: “The greatest investment risk is not the volatility of prices, but whether you suffer a permanent loss of capital.” When we think about how risky a business is, we always like to look at the use of debt, as over-indebtedness can lead to ruin. We make a note of that STO Co., Ltd. (KOSDAQ: 098660) has debt on its balance sheet. But the more important question is, what is the risk this debt poses?
What is the risk of debt?
In general, debt doesn’t become a real problem until a company can’t simply pay it off, whether through raising capital or using its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still expensive) situation is that a company needs to dilute shareholders on a cheap stock price just to get the debt under control. The advantage of debt, of course, is that it is often cheap capital, especially when it replaces the dilution of a business with the ability to reinvest too high a return. The first thing to do when considering how much debt a company uses is to put its cash and debt together.
How much debt does STO owe?
The image below, which you can click for more details, shows that STO had debt of 19.5 billion at the end of September 2020, but since it has a cash reserve of 3.70 billion yen, its net debt is around 15.8 billion Yen lower.
A look at STO’s liabilities
According to the most recently published balance sheet, STO had liabilities of $ 29.7 billion due within 12 months and liabilities of $ 11.4 billion due beyond 12 months. This was offset by cash and cash equivalents of 3.70 billion and receivables of 6.16 billion that were due within 12 months. So its liabilities are 31.2 billion more than the combination of cash and short-term receivables.
That deficit is sizeable relative to its market capitalization of ₩36.0 billion, so shareholders should keep an eye on the use of STO. Should their lenders request that they support the balance sheet, shareholders would likely face severe dilution.
We measure a company’s debt burden in relation to its profitability by dividing its net debt by earnings before interest, taxes, depreciation and amortization (EBITDA) and calculating how easily earnings before interest and taxes (EBIT) cover its interest costs (interest coverage ). In this way we take into account both the absolute amount of the debt and the interest paid on it.
While we wouldn’t worry about the net debt to EBITDA ratio of 2.8, we think the extremely low interest coverage of 1.8 times is a sign of high leverage. This is in large part due to the company’s significant depreciation and amortization charges, which arguably mean its EBITDA is a very generous earnings metric and its debt may be a bigger burden than it first appears. It seems clear that the cost of borrowing has been negatively impacting shareholder returns recently. Worse still, STO has seen an EBIT tank of 55% over the past 12 months. If the revenue continues like this over the long term, there is a hell of a chance of paying off that debt. The balance sheet is clearly the area to focus on when analyzing debt. But you can’t look at debt in complete isolation; because STO needs revenue to service this debt. So if you want to know more about earnings, it might be worth taking a look this graph of the long-term earnings trend.
After all, a business needs free cash flow to pay off debts; Accounting profits just don’t cut it off. That is why we always check how much of this EBIT is converted into free cash flow. Fortunately for all shareholders, STO has actually produced more free cash flow than EBIT over the past three years. This type of strong money generation warms our hearts like a puppy in a bumblebee suit.
To be honest, both STO’s interest coverage and its track record of (not) rising EBIT make us pretty uncomfortable with its debt levels. On the positive side, however, the conversion of EBIT into free cash flow is a good sign and makes us more optimistic. When we look at all of the above factors together, it seems to us that STO’s debts make it a bit risky. That’s not necessarily a bad thing, but we’d generally be more comfortable with less leverage. When analyzing debt levels, the obvious starting point is the balance sheet. But ultimately, any business can involve off-balance sheet risks. These risks can be difficult to spot. Every company has them and we discovered them 7 warning signs for STO (of which 2 concern!) you should know.
After all that, if you’re more interested in a fast-growing company with a rock-solid balance sheet, stop by our list of net cash growth stocks without delay.
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