Here's Why Yutaka GikenLtd (TYO:7229) Can Manage Its Debt Responsibly

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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, Yutaka Giken Co.,Ltd. (TYO:7229) does carry debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

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. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Yutaka GikenLtd

What Is Yutaka GikenLtd's Debt?

The image below, which you can click on for greater detail, shows that at September 2020 Yutaka GikenLtd had debt of JP¥10.7b, up from JP¥9.00b in one year. However, it does have JP¥21.5b in cash offsetting this, leading to net cash of JP¥10.9b.

How Strong Is Yutaka GikenLtd's Balance Sheet?

We can see from the most recent balance sheet that Yutaka GikenLtd had liabilities of JP¥80.0b falling due within a year, and liabilities of JP¥6.90b due beyond that. On the other hand, it had cash of JP¥21.5b and JP¥61.1b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by JP¥4.32b.

Of course, Yutaka GikenLtd has a market capitalization of JP¥24.1b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. While it does have liabilities worth noting, Yutaka GikenLtd also has more cash than debt, so we're pretty confident it can manage its debt safely.

The modesty of its debt load may become crucial for Yutaka GikenLtd if management cannot prevent a repeat of the 87% cut to EBIT over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Yutaka GikenLtd will need earnings to service that debt. 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 company can only pay off debt with cold hard cash, not accounting profits. While Yutaka GikenLtd has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the most recent three years, Yutaka GikenLtd recorded free cash flow worth 75% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Summing up

Although Yutaka GikenLtd's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of JP¥10.9b. The cherry on top was that in converted 75% of that EBIT to free cash flow, bringing in JP¥1.2b. So we are not troubled with Yutaka GikenLtd's debt use. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 2 warning signs for Yutaka GikenLtd (1 makes us a bit uncomfortable!) that you should be aware of before investing here.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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