Here's Why Yokohama Rubber Company (TSE:5101) Can Manage Its Debt Responsibly

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that The Yokohama Rubber Company, Limited (TSE:5101) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

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. 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 examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Yokohama Rubber Company

What Is Yokohama Rubber Company's Net Debt?

As you can see below, Yokohama Rubber Company had JP¥457.4b of debt at September 2024, down from JP¥530.9b a year prior. However, because it has a cash reserve of JP¥107.5b, its net debt is less, at about JP¥349.9b.

A Look At Yokohama Rubber Company's Liabilities

Zooming in on the latest balance sheet data, we can see that Yokohama Rubber Company had liabilities of JP¥343.8b due within 12 months and liabilities of JP¥460.9b due beyond that. Offsetting this, it had JP¥107.5b in cash and JP¥247.2b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by JP¥449.9b.

This is a mountain of leverage relative to its market capitalization of JP¥493.3b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).

Yokohama Rubber Company's net debt to EBITDA ratio of about 1.8 suggests only moderate use of debt. And its commanding EBIT of 16.0 times its interest expense, implies the debt load is as light as a peacock feather. It is well worth noting that Yokohama Rubber Company's EBIT shot up like bamboo after rain, gaining 75% in the last twelve months. That'll make it easier to manage its debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Yokohama Rubber Company can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent three years, Yokohama Rubber Company recorded free cash flow of 31% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Yokohama Rubber Company's interest cover was a real positive on this analysis, as was its EBIT growth rate. On the other hand, its level of total liabilities makes us a little less comfortable about its debt. Looking at all this data makes us feel a little cautious about Yokohama Rubber Company's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Be aware that Yokohama Rubber Company is showing 2 warning signs in our investment analysis , and 1 of those shouldn't be ignored...

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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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.