Is Nippon Pallet Pool (TYO:4690) Using Too Much Debt?

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.' 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 Nippon Pallet Pool Co., Ltd. (TYO:4690) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Nippon Pallet Pool

How Much Debt Does Nippon Pallet Pool Carry?

You can click the graphic below for the historical numbers, but it shows that Nippon Pallet Pool had JP¥3.85b of debt in September 2020, down from JP¥4.52b, one year before. However, because it has a cash reserve of JP¥698.0m, its net debt is less, at about JP¥3.15b.

How Healthy Is Nippon Pallet Pool's Balance Sheet?

The latest balance sheet data shows that Nippon Pallet Pool had liabilities of JP¥3.24b due within a year, and liabilities of JP¥2.46b falling due after that. Offsetting this, it had JP¥698.0m in cash and JP¥876.0m in receivables that were due within 12 months. So its liabilities total JP¥4.12b more than the combination of its cash and short-term receivables.

Given this deficit is actually higher than the company's market capitalization of JP¥2.96b, we think shareholders really should watch Nippon Pallet Pool's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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

Nippon Pallet Pool's net debt is only 1.00 times its EBITDA. And its EBIT easily covers its interest expense, being 26.1 times the size. So we're pretty relaxed about its super-conservative use of debt. In addition to that, we're happy to report that Nippon Pallet Pool has boosted its EBIT by 77%, thus reducing the spectre of future debt repayments. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Nippon Pallet Pool 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Happily for any shareholders, Nippon Pallet Pool actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

Nippon Pallet Pool's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But we must concede we find its level of total liabilities has the opposite effect. All these things considered, it appears that Nippon Pallet Pool can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. 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. Case in point: We've spotted 3 warning signs for Nippon Pallet Pool 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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