Is SANNO (TYO:3441) Using Too Much Debt?

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies SANNO Co., Ltd. (TYO:3441) makes use of debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. 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 Debt?

You can click the graphic below for the historical numbers, but it shows that as of July 2020 SANNO had JP¥4.63b of debt, an increase on JP¥3.68b, over one year. However, because it has a cash reserve of JP¥2.68b, its net debt is less, at about JP¥1.95b.

How Healthy Is SANNO's Balance Sheet?

According to the last reported balance sheet, SANNO had liabilities of JP¥3.34b due within 12 months, and liabilities of JP¥2.74b due beyond 12 months. Offsetting this, it had JP¥2.68b in cash and JP¥2.38b in receivables that were due within 12 months. So its liabilities total JP¥1.02b more than the combination of its cash and short-term receivables.

Of course, SANNO has a market capitalization of JP¥6.69b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

SANNO's debt is 3.6 times its EBITDA, and its EBIT cover its interest expense 6.4 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. We also note that SANNO improved its EBIT from a last year's loss to a positive JP¥180m. The balance sheet is clearly the area to focus on when you are analysing debt. But it is SANNO's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, SANNO saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

SANNO's struggle to convert EBIT to free cash flow had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. But on the bright side, its ability to to cover its interest expense with its EBIT isn't too shabby at all. When we consider all the factors discussed, it seems to us that SANNO is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. 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 instance, we've identified 4 warning signs for SANNO (2 are significant) you should be aware of.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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