These 4 Measures Indicate That Diamond Electric Holdings (TSE:6699) Is Using Debt Extensively

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, Diamond Electric Holdings Co., Ltd. (TSE:6699) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Diamond Electric Holdings

What Is Diamond Electric Holdings's Net Debt?

As you can see below, Diamond Electric Holdings had JP¥38.5b of debt at September 2024, down from JP¥41.0b a year prior. However, it also had JP¥9.11b in cash, and so its net debt is JP¥29.4b.

How Healthy Is Diamond Electric Holdings' Balance Sheet?

The latest balance sheet data shows that Diamond Electric Holdings had liabilities of JP¥53.4b due within a year, and liabilities of JP¥15.8b falling due after that. Offsetting these obligations, it had cash of JP¥9.11b as well as receivables valued at JP¥12.9b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by JP¥47.1b.

This deficit casts a shadow over the JP¥4.47b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Diamond Electric Holdings would likely require a major re-capitalisation if it had to pay its creditors today.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). 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).

Diamond Electric Holdings shareholders face the double whammy of a high net debt to EBITDA ratio (8.1), and fairly weak interest coverage, since EBIT is just 1.0 times the interest expense. This means we'd consider it to have a heavy debt load. However, it should be some comfort for shareholders to recall that Diamond Electric Holdings actually grew its EBIT by a hefty 1,665%, over the last 12 months. If it can keep walking that path it will be in a position to shed its debt with relative ease. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Diamond Electric Holdings'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 company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last two years, Diamond Electric Holdings burned a lot of cash. 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.

Our View

On the face of it, Diamond Electric Holdings's conversion of EBIT to free cash flow left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Taking into account all the aforementioned factors, it looks like Diamond Electric Holdings has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. 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. We've identified 3 warning signs with Diamond Electric Holdings (at least 1 which shouldn't be ignored) , and understanding them should be part of your investment process.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.