Here's Why HKS (TYO:7219) Has A Meaningful Debt Burden

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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, HKS Co., Ltd. (TYO:7219) does carry debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, 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.

View our latest analysis for HKS

What Is HKS's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of August 2020 HKS had JP¥1.49b of debt, an increase on JP¥1.32b, over one year. But it also has JP¥2.31b in cash to offset that, meaning it has JP¥814.0m net cash.

How Strong Is HKS's Balance Sheet?

We can see from the most recent balance sheet that HKS had liabilities of JP¥2.08b falling due within a year, and liabilities of JP¥1.06b due beyond that. On the other hand, it had cash of JP¥2.31b and JP¥1.03b worth of receivables due within a year. So it can boast JP¥194.0m more liquid assets than total liabilities.

This surplus suggests that HKS has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that HKS has more cash than debt is arguably a good indication that it can manage its debt safely.

It is just as well that HKS's load is not too heavy, because its EBIT was down 51% over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. When analysing debt levels, the balance sheet is the obvious place to start. But it is HKS's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. HKS may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last three years, HKS saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that HKS has net cash of JP¥814.0m, as well as more liquid assets than liabilities. So although we see some areas for improvement, we're not too worried about HKS's balance sheet. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Consider for instance, the ever-present spectre of investment risk. We've identified 4 warning signs with HKS (at least 1 which is a bit unpleasant) , and understanding them should be part of your investment process.

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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This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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