Is SANNO (TYO:3441) A Risky Investment?

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.' 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. We note that SANNO Co., Ltd. (TYO:3441) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

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. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. 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 SANNO

What Is SANNO's Net Debt?

As you can see below, SANNO had JP¥3.86b of debt at January 2021, down from JP¥4.24b a year prior. On the flip side, it has JP¥2.04b in cash leading to net debt of about JP¥1.82b.

How Healthy Is SANNO's Balance Sheet?

We can see from the most recent balance sheet that SANNO had liabilities of JP¥3.26b falling due within a year, and liabilities of JP¥1.74b due beyond that. Offsetting this, it had JP¥2.04b in cash and JP¥1.92b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by JP¥1.04b.

Given SANNO has a market capitalization of JP¥6.68b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

SANNO's debt is 3.4 times its EBITDA, and its EBIT cover its interest expense 5.2 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. We also note that SANNO improved its EBIT from a last year's loss to a positive JP¥152m. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since SANNO will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, SANNO 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.

Our View

SANNO's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. For example, its level of total liabilities is relatively strong. When we consider all the factors discussed, it seems to us that SANNO is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 4 warning signs with SANNO (at least 1 which makes us a bit uncomfortable) , 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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