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, Otec Corporation (TYO:1736) does carry debt. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.
View our latest analysis for Otec
How Much Debt Does Otec Carry?
As you can see below, Otec had JP¥811.0m of debt at September 2020, down from JP¥1.28b a year prior. But on the other hand it also has JP¥9.87b in cash, leading to a JP¥9.06b net cash position.
How Strong Is Otec's Balance Sheet?
The latest balance sheet data shows that Otec had liabilities of JP¥7.86b due within a year, and liabilities of JP¥965.0m falling due after that. Offsetting these obligations, it had cash of JP¥9.87b as well as receivables valued at JP¥6.01b due within 12 months. So it can boast JP¥7.05b more liquid assets than total liabilities.
This luscious liquidity implies that Otec's balance sheet is sturdy like a giant sequoia tree. With this in mind one could posit that its balance sheet is as strong as beautiful a rare rhino. Simply put, the fact that Otec has more cash than debt is arguably a good indication that it can manage its debt safely.
On the other hand, Otec saw its EBIT drop by 7.4% in the last twelve months. That sort of decline, if sustained, will obviously make debt harder to handle. There's no doubt that we learn most about debt from the balance sheet. But it is Otec'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Otec 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 last three years, Otec recorded free cash flow worth a fulsome 86% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.
Summing up
While it is always sensible to investigate a company's debt, in this case Otec has JP¥9.06b in net cash and a decent-looking balance sheet. The cherry on top was that in converted 86% of that EBIT to free cash flow, bringing in JP¥1.8b. So is Otec's debt a risk? It doesn't seem so to us. 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. Take risks, for example - Otec has 1 warning sign we think you should be aware of.
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. 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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About TSE:1736
Flawless balance sheet established dividend payer.
