Republic of Korea: Selected Issues
Author: International Monetary Fund
Publication Date:
17 Jul 2001
eISBN:
9781451822052
Language:
English
Keywords:
ISCR; CR; output gap; debt-equity ratio; interest coverage ratio Top-4; profitability remains weak; current liabilities; profitability indicator; Personal income; Corporate sector; Financial statements; Sensitivity analysis; Interest payments
Download PDF (1,008 KB)

The paper discusses potential output, the output gap, and inflation in Korea. The paper explores the information content of potential leading indicators of inflation. A broadly balanced current account has been the suggested norm for Korea over the medium term. The challenge is to help build a more robust bond market that prices risk appropriately. The features of pension schemes in Korea and the problems they face are outlined. The paper reviews pension reform, banking sector, corporate sector, and foreign exchange crises with respect to Korea.

Abstract

The paper discusses potential output, the output gap, and inflation in Korea. The paper explores the information content of potential leading indicators of inflation. A broadly balanced current account has been the suggested norm for Korea over the medium term. The challenge is to help build a more robust bond market that prices risk appropriately. The features of pension schemes in Korea and the problems they face are outlined. The paper reviews pension reform, banking sector, corporate sector, and foreign exchange crises with respect to Korea.

VII. Health of the Corporate Sector in Korea1

The corporate sector has made progress in improving its capital structure and profitability since the crisis. Debt ratios have come down and corporate cash flow has improved owing in part to the economic recovery. However, the corporate sector continues to suffer from poor profitability and remains highly leveraged by international standards. The return to profitability has been constrained by the large debt service burden. An analysis of the interest coverage ratio for the top-64 chaebol affiliates in 1999 show that about one in four companies were still unable to generate enough cashflow to meet their interest payments. Further, a sensitivity analysis of the corporate sector to changes in the interest rate and to debt levels indicates that the corporate sector remains vulnerable to a sharp rise in interest rates and that there are still significant gains from further deleveraging and operational restructuring in terms of improving profitability and reducing corporate vulnerability.

A. Introduction

1. Since the crisis, resolving the problems in the corporate sector has been at the forefront of Korea’s reform drive. The objective has been to address the underlying structural weaknesses that left Korea vulnerable to an external crisis, and to create a more competitive and vibrant corporate sector. Over the past three years, progress has been made in restructuring the corporate sector. Debt-equity ratios have fallen from their excessively high levels; financial disclosure and corporate governance have improved; and the strong economic recovery has helped to improve cash flows and created new financing. However, Korea’s corporate sector still remains highly leveraged and continues to suffer from low profitability, indicating that much more restructuring needs to be done.

2. The purpose of this chapter is to assess the health of the corporate sector since the crisis. The paper examines various financial indicators to describe the progress made by the corporate sector in improving its capital structure and raising profitability. In addition, the paper uses firm-level financial data for the affiliates of the top-64 chaebol to calculate interest coverage ratios—a measure of a firm’s capacity to service its debt—as way of providing a more complete picture of corporate health. A sensitivity analysis was also done to assess the vulnerability of the corporate sector to increases in interest rates and to gauge the potential gains from further deleveraging.

B. Corporate Sector Developments in 1999

Capital structure

3. Although progress has been made in reducing debt-equity ratios, the corporate sector remains highly leveraged by international standards. The average debt-to-equity ratio for the nonfinancial corporate sector declined from a high of 425 percent in 1997 to 235 percent in 1999. For the manufacturing sector, whose assets make up over half of the nonfinancial corporate sector, the average debt-to-equity ratio fell from 396 percent in 1997 to 215 percent at end-1999; as of end-June 2000, it stood at 193 percent. Despite the decline, the debt-to-equity ratio in the manufacturing sector still remains high compared to a sample of other advanced countries (Table VII.1 and Chart VII.1). Other financial indicators, such as the ratio of total borrowings and bonds payable to assets and borrowings to sales, indicate that the manufacturing sector is still heavily dependent upon debt financing.

Table VII.1.

Korea: Indicators of Financial Stability and Dependence on Borrowed Funds in Manufacturing, 1997-99

(In percent)

article image
Sources: BOK, Financial Statement Analysis for 1999 and national sources.
Chart VII.1.
Chart VII.1.

Korea: Profitability and Liquidity Ratios in Manufacturing, 1990-99

Citation: IMF Staff Country Reports 2001, 101; 10.5089/9781451822052.002.A007

Source: BOK, Financial Statement Analysis for 1999; national sources.1/ Defined as net income as a percent of total assets.2/ Includes interest income / expenses and losses and gains from foreign currency transactions and disposals of investments and tangible assets.

4. Debt ratios improved in most sectors in 1999, except for wholesale and retail trade which experienced a large jump in 1999 on account of losses by a few large enterprises (Table VII.2). Both small and large sized manufacturing firms managed to undertake significant deleveraging since the crisis. Although the construction sector lowered its debt ratio substantially in 1999, it still remains one of the most leveraged sectors. On the other hand, the information technology industry, which traditionally relies more upon equity and venture capital financing, had one of the lowest debt ratios.

Table VII.2.

Korea: Debt-Equity Ratios, by Sector, 1997-99

(In percent)

article image
Source: BOK, Financial Statement Analysis for 1999.

5. The corporate sector has also improved its debt structure since the crisis. The share of short-term debt in total debt fell from 25½ percent in 1997 to 18½ percent in 1999, and the average interest rate on debt declined to around its pre-crisis level of 10½ percent. However, the current ratio (current assets/current liabilities), a measure of a firm’s liquidity, was 94½ percent in 1999, basically unchanged from 1997 and indicating that current assets could not meet current liabilities in the event of a credit cut-off.

6. However, much of the improvement was due to issuances of new equity rather than debt reduction. Total liabilities for the nonfinancial corporate sector fell by only W 6.5 trillion in 1999 to W 725 trillion (137 percent of GDP) while the stock of total equity (book value) increased by W 91 trillion. Taking advantage of the rising stock market, the flow of equity financing jumped from W 15 trillion in 1998 to W 42 trillion in 1999, replacing bond issuances as the primary source of financing (Table VII.3). Bond financing fell sharply in 1999 following the collapse of the Daewoo Group and the difficulties faced by investment trust companies (ITCs) which have traditionally been large buyers of corporate bonds. This pattern continued in the first half of 2000, though equity financing has declined in line with the slumping stock market.

Table VII.3.

Korea: Trends in the Structure of Corporate Finance, 1997-2000

(Non-financial enterprises; flow data; in trillions of won)

article image
Source: BOK.

7. Since 1997, equity issuance and bank borrowing have replaced new bonds as the main source of corporate financing and have been used to retire debt owed to the nonbank sector, primarily ITCs and merchant banks, through loan repayments and redemption of commercial paper. These repayments amounted to W 58 trillion during 1998-99. Banks, on the other hand, have re-emerged as major lenders to the corporate sector in 1999, and with the slowdown in equity financing were the largest source of financing in the first half of 2000.

Indicators of profitability

8. Manufacturing profitability has improved over the last three years, owing in part to the economic recovery. Revenue from sales grew by 8 percent in 1999 up from 0.7 percent in 1998, and the ratio of operating income to sales (i.e. profit margin) increased slightly in 1999, largely due to lower costs associated with bad debts and material purchases and a pickup in revenue (Table VII.4). Ordinary income to sales, which takes into account financial expenses, foreign currency transactions, and disposals of assets, also turned positive for the first time in two years, mainly as a result of lower interest rates and net gains on asset sales. Other indicators, such as return on assets (ROA), also rebounded somewhat in 1999, but still remained low compared to Japan, Taiwan, P.O.C., and the U.S. (Chart VII.1).2

Table VII.4.

Korea: Indicators of Profitability in Manufacturing, 1997-99

(In percent)

article image
Sources: BOK, Financial Statement Analysis for 1999 and national sources.

Operating income is the difference between the revenue of a business and its related costs and expenses, excluding income derived from sources outside its regular activities.

Ordinary income is operating income after losses or gains from interest expenses/income, foreign currency transactions, and disposals of investments and tangible assets.

9. However, manufacturing profitability remains weak and is constrained by the large debt service burden. Table VII.4 shows that operating income to sales compares favorably with a small sample of other countries, but that after accounting for nonoperating income and expenses, Korean corporate performance suffers markedly. The large gap between operating income and ordinary income to sales in Korea is due mainly to interest expenses which cut heavily into profits. The interest burden on accumulated debt accounts for almost all of nonoperating expenses in Korea and is much higher relative to sales than in Japan, the U.S., and Taiwan, P.O.C.

10. The nonmanufacturing sectors also showed a similar pattern of heavy interest expenses cutting into stronger earnings. For example, ordinary income to sales in the construction sector improved slightly in 1999 but remained negative (-3.1) as result of its large interest burden (Table VII.5). The interest burden was also greater for the large enterprises than for the small and medium-sized ones. Not surprisingly, sectors with low debt ratios, such as information technology and transport, storage and communication, recorded higher net profits, helped in part by their low interest expenses.

Table VII.5.

Korea: Profitability Indicators, by Sector, 1999

(In percent)

article image
Source: BOK, Financial Statement Analysis for 1999.

Results of the 1999 combined financial statements (CFS)

11. On August 1, 2000, the Financial Supervisory Services (FSS) released for the first time a report on the combined financial statements (CFS) for sixteen large Korean chaebol for fiscal year 1999. The release of the CFS represents an important step in the Korean government’s drive to improve financial disclosure and transparency and to bring Korean accounting standards up to the level of international best practices. “Combined” statements apply the principle of consolidated accounting to companies that do not necessarily have any shareholding links but are under common control. This is a common form of organization of Korean chaebol where control is exerted through family shareholdings in individual companies rather than through a parent holding company. The CFS nets out the effects of intra-group transactions in presenting one financial statement for each chaebol group and treats all its affiliated companies, regardless of voting interest, as one economic entity.

12. Not surprisingly, the CFS revealed higher debt-to-equity ratios than what had been reported under the consolidated framework. The average debt-to-equity ratio for the conglomerates, excluding financial institutions, was 225 percent at the end of fiscal year 1999 (Table VII.6). Hyundai, LG, and SK all had debt ratios that exceeded the government mandated threshold of 200 percent. The higher debt ratios for the top-4 chaebol reflected both higher reported debt (by $ 14 billion) and lower equity (by $10 billion). For the remaining chaebol, the debt ratios varied from a low of 82 percent for Lotte to a high of 1,789 percent for Ssangyong.

Table VII.6.

Korea: Key Financial Indicators under CFS, 1999

article image
Source: FSS.

“Current” refers to assets which can be converted within one year or liabilities with a maturity of one year.

13. The CFS also showed that chaebol were still suffering from poor operating performance. Nine of the sixteen chaebol reported an interest-coverage ratio (operating income divided by interest expense) of less than one, indicating that operating income was insufficient to cover their interest payments, let alone their principal obligations. Of the top-4, Hyundai was the worst performer with a ratio of 0.91 while Samsung was the best at 3.1. In addition, the average ratio of current assets to current liabilities was 0.81, implying that in the event of a cutoff in credit lines, many chaebol would not be able to cover their short-term debts with current assets that can be liquidated within one year. These figures imply that a majority of the 16 companies still remain highly leveraged and vulnerable to a rise in interest rates, a cutoff in bank lending, or a slowdown in the economy.

Interest coverage ratios for top-64 chaebol

14. The focus of corporate restructuring in Korea has been on reducing debt-equity ratios, but this presents an incomplete picture of corporate health. For example, although the Hyundai group (along with LG, Samsung and SK) managed to reduce its debt-to-equity ratio to below 200 percent by end-1999 (on a consolidated statement basis), several of its affiliates continued to experience financial difficulties.

15. The interest coverage ratio (ICR) is defined as earnings before interest, tax, depreciation, and amortization (EBITDA) over interest expense and is a measure of a firm’s capacity to cover its interest payments on its outstanding loans.3 If a firm has an ICR of below 1, it is unable to meet its interest payments, let alone its principal obligations, using its current earnings. In the U.S., the average ICR in 1996 was around 8, and in order to earn an A-rating based upon Standard & Poor’s rating requirements, a U.S. company typically must have a ratio of operating cash flow to interest of more than 8.

16. Despite the improvement in operating performance in 1999, about one in four companies were still unable to generate enough cash flow to meet their interest payments.4

  • In 1999, the average ICR for the companies in the sample was 2.3, up from 1.4 in 1998. However, 23 percent of the top-64 chaebol affiliates had an ICR below one, including 13 percent which recorded negative EBITDA (Table VII.7).5 This result is consistent with BOK’s analysis of 3,703 companies in the manufacturing industry which showed that in 1999, roughly 1 in 4 manufacturers were unable to pay their financial costs with their cash income.6

Table VII.7.

Summary of Interest Coverage Ratios for Top-64 Chaebol

In 1999, the average interest coverage ratio (ICR) for the 496 companies (excluding Daewoo affiliates) in the sample was 2.30, with roughly one in four companies with an ICR of below 1. Medium-size chaebol were in a much weaker financial position than the top-4.

article image
Source: Data provided by IFC and compiled by Korea Investor Service from 1999 financial statements.

Interest coverage ratio is measured as EBITDA/interest expense.

  • Further, a more recent BOK study of 1,807 manufacturing companies in the first half of 2000 found that about 27 percent still had an ICR of less than one.

17. A further examination showed that financial position of the medium-size chaebol affiliates was much weaker than for the top-4 affiliates. The average ICR for the medium-size chaebol was 1.6 compared to 2.9 for the top-4 affiliates. The medium-size chaebol also had a larger share of companies with an ICR of below one and a larger share of “precautionary” debt (Chart VII.2).

Chart VII.2.
Chart VII.2.

Korea: Share of Companies with ICR Below and Equal to 1, 1999

(EBITDA / Interest Expense)

Citation: IMF Staff Country Reports 2001, 101; 10.5089/9781451822052.002.A007

18. The average interest rate for all affiliates was around 14 percent and did not vary much by size of chaebol. Korean firms issued W 28 trillion of corporate bonds in 1997 and W 46½ trillion in 1998, much of it with a 3-year maturity and at high rates. The average 3 year corporate bond rate has come down substantially from 20 percent in early 1998 to around 8.5-9.0 percent as of end-2000. Consequently, the average interest rate payable on accumulated debt is expected to come down further, as this debt is refinanced or rolled-over at the lower rate.

C. Sensitivity Analysis

19. A sensitivity analysis reveals that although a modest increase in interest rates would have only a minimal impact, a sharp rise could lead to further corporate distress.

  • For example, a 100 basis point increase in the effective borrowing rate over a one-year period would have raised the number of companies with an ICR of below one by only 6 and lowered slightly the average interest coverage ratio for the sector from 2.30 to 2.14.

  • However, a significantly larger increase in interest rates, say by 5 percentage points over a one-year period, would have reduced the interest coverage ratio to 1.69 and raised the number of companies with an ICR of below one by 33.

  • A 5 percentage point increase in interest rates would have created an additional W 18½ trillion in “precautionary” debt representing 31 percent of all interest-bearing debt.

20. A further examination shows that because of their weaker financial position, medium-size chaebol are much more vulnerable to a rise in interest rates than the top-4. For example, a 5 percentage point increase in interest rates would have lowered the ICR for the top-4 from 2.9 to 2.1 compared to 1.6 to 1.2 for medium-size firms. The share of “precautionary” debt would have risen from 15 percent to 27 percent for the top-4 compared 26 percent to 35 percent for the medium-size chaebol (Chart VII.3).

Chart VII.3.
Chart VII.3.

Korea: Interest Rate Sensitivity Analysis of Interest Coverage Ratio Top-4 vs. Medium-Size Chaebol Affiliates, 1999

In 1999, medium-size chaebol affiliates started from a weaker financial position and were more vulnerable to a rise in interest rates than the top-4.

Citation: IMF Staff Country Reports 2001, 101; 10.5089/9781451822052.002.A007

1/ “Precautionary” here is defined as interest bearing debt for companies with an interest coverage ratio of below 1 in 1999.

21. A broader analysis which included also principal payments falling due (i.e. a debt service coverage ratio) would likely show that many more firms would be unable to meet their principal obligations with current income. W 61 trillion of corporate bonds is expected to mature in 2001, representing some 45 percent of the outstanding amount (Table VII.8).7 While some of this is likely to be refinanced and at a lower rate, firms with a poor cash flow position would likely face difficulties in rolling over this debt and remain vulnerable to a cutoff in credit lines.

Table VII.8.

Korea: Maturing Corporate Bonds, 1999-01

(in trillions of won; as of end-September 2000)

article image
Source: BOK.

22. Further deleveraging and operational restructuring is needed to improve the profitability and cash flow position of Korean corporations. A second sensitivity analysis shows that further debt reduction would have significantly improved interest coverage ratios and lowered the amount of “precautionary” loans for both the top-4 and medium-size chaebol.

  • For example, a reduction of interest-bearing debt by 10 percent in 1999 would have raised the average ICR from 2.33 to 2.55 and reduced the amount of “precautionary” debt by W 4½ trillion. The improvement would have been greater for the medium-size chaebol than for the top-4 (Chart VII.4).

Chart VII.4.
Chart VII.4.

Korea: Sensitivity Analysis of Interest Coverage Ratio to Debt Reduction Top-4 vs. Medium-Size Chaebol Affiliates, 1999

Reducing the overall level of debt in 1999 would have significantly improved the interest coverage ratios and reduced the share of “precautionary” loans for both the top-4 and the medium-size chaebol affiliates. 1/

Citation: IMF Staff Country Reports 2001, 101; 10.5089/9781451822052.002.A007

1/“Precautionary” here is defined as interest bearing debt for companies with an interest coverage ratio of below 1 in 1999.

  • A significantly larger reduction of debt, say by 20 percent, in 1999 would have raised the average ICR to 2.87 and reduced the amount of “precautionary” debt by W 14 trillion.8 In particular, the share of “precautionary” debt for the top-4 would have fallen from 15 percent of the total to around 6½ percent.

D. Conclusion

23. Despite the progress made so far, the corporate sector still remains highly leveraged and continues to suffer from low profitability. The average debt-equity ratio remains high by international standards. Although cash flows have improved owing in part to the economic recovery, profitability continues to suffer, mainly due to the large interest payments needed to finance the debt. An analysis of the interest coverage ratios for the top-64 chaebol affiliates reveals that about one in four companies were unable to generate enough cash flow to meet their interest payments in 1999. Other studies have confirmed that this trend continued into 2000. A weak corporate sector will continue to be a source of instability and drag on the rest of the economy.

24. Further deleveraging and operational restructuring is needed to improve the profitability and resilience of the Korean corporate sector to adverse shocks. Sectors that have managed to reduce significantly their debt-equity ratios have in general shown better operating performance while those that remain saddled with large debts have fared much worse. The large debt burden also leaves the corporate sector vulnerable to financing difficulties and an economic downturn. For example, a sensitivity analysis shows that although a modest increase in interest rates would have only a minimal impact, a sharp rise or a cutoff in credit lines could lead to further corporate distress and raise significantly the amount of nonperforming loans. Because of their weaker financial position, medium-size chaebol affiliates in particular remain vulnerable to adverse shocks.

25. The analysis could be updated and expanded in several ways. For example, it would be useful to update the sensitivity analysis using data through end-June 2000, though financial data is released usually with a six month lag. It would also be useful to separate workout (informal and court-supervised) versus non-workout firms in the sample to assess their performance and vulnerability. Finally, it would useful to include information on capital structure (e.g. debt-equity, short-term vs. long-term assets and liabilities, weighted-average cost of capital) and operational performance (return on assets, return on invested capital) to see whether there is a correlation between capital structure and profitability and to examine whether companies with sound fundamentals are still suffering from excessive debt service burdens as a result of their high leverage.

1

This chapter was prepared by Kenneth H. Kang.

2

A report by the LG Economic Research Institute (LGERI), which examined financial data from 164 nonfinancial companies of the top 60 business groups listed on the Korea Stock Exchange, found that profitability and sales continued to improve in the first half of 2000 (“The Validity of Interest Coverage Ratio,” LGERI, October 19, 2000).

3

Other firm-level analyses have used EBIT (earnings before interest and taxes) which excludes depreciation and therefore usually shows a lower value for earnings (and therefore a lower ICR) than does EBITDA. However, EBITDA which includes depreciation, is regarded as a more accurate measure of a firm’s cash flow position and short-term ability to finance its loan obligations. EBIT is used more often because of the ease in collecting the data and in drawing comparisons with other countries.

4

The analysis here uses firm level financial data for 496 companies of the top-64 chaebol groups in 1999 (excluding Daewoo) compiled by IFC using data from the Korea Investor Services.

5

Many of the worst performers represented companies in workout programs or in court receivership. Here, distressed debt of companies with an ICR of below 1 (so called “precautionary” debt) made up roughly 20 percent of the total interest-bearing debt.

6

“Manufacturing Industries: Analysis of Cash Flow during 1999,” Bank of Korea, August, 2000.

7

As mentioned earlier, much of this was issued shortly after the crisis in early 1998 with a standard 3-year maturity.

8

To have a sense of its impact on its leverage ratio, a 10 percent reduction in debt for the top-4 chaebol would have lowered their debt-equity ratios in 1999 from 255 percent to 203 percent (according to their combined financial statements). A 20 percent debt reduction would have lowered their debt-equity ratios to 180 percent.

Same Series

Other IMF Content

Other Publishers

Cover IMF Staff Country Reports
Republic of Korea: Selected Issues
Author: International Monetary Fund
Volume/Issue:
Volume 2001: Issue 101
Publisher:
International Monetary Fund
ISBN:
9781451822052
ISSN:
1934-7685
Pages:
143
DOI:
https://doi.org/10.5089/9781451822052.002
  • View in gallery

    Korea: Profitability and Liquidity Ratios in Manufacturing, 1990-99

  • View in gallery

    Korea: Share of Companies with ICR Below and Equal to 1, 1999

    (EBITDA / Interest Expense)

  • View in gallery

    Korea: Interest Rate Sensitivity Analysis of Interest Coverage Ratio Top-4 vs. Medium-Size Chaebol Affiliates, 1999

    In 1999, medium-size chaebol affiliates started from a weaker financial position and were more vulnerable to a rise in interest rates than the top-4.

  • View in gallery

    Korea: Sensitivity Analysis of Interest Coverage Ratio to Debt Reduction Top-4 vs. Medium-Size Chaebol Affiliates, 1999

    Reducing the overall level of debt in 1999 would have significantly improved the interest coverage ratios and reduced the share of “precautionary” loans for both the top-4 and the medium-size chaebol affiliates. 1/

Korea: Profitability and Liquidity Ratios in Manufacturing, 1990-99

Korea: Share of Companies with ICR Below and Equal to 1, 1999

(EBITDA / Interest Expense)

Korea: Interest Rate Sensitivity Analysis of Interest Coverage Ratio Top-4 vs. Medium-Size Chaebol Affiliates, 1999

In 1999, medium-size chaebol affiliates started from a weaker financial position and were more vulnerable to a rise in interest rates than the top-4.

Korea: Sensitivity Analysis of Interest Coverage Ratio to Debt Reduction Top-4 vs. Medium-Size Chaebol Affiliates, 1999

Reducing the overall level of debt in 1999 would have significantly improved the interest coverage ratios and reduced the share of “precautionary” loans for both the top-4 and the medium-size chaebol affiliates. 1/