Nippon Pallet Pool (TYO:4690) Has A Pretty Healthy Balance Sheet

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. As with many other companies Nippon Pallet Pool Co., Ltd. (TYO:4690) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Nippon Pallet Pool

What Is Nippon Pallet Pool's Net Debt?

The image below, which you can click on for greater detail, shows that Nippon Pallet Pool had debt of JP¥3.59b at the end of December 2020, a reduction from JP¥4.21b over a year. However, it also had JP¥734.0m in cash, and so its net debt is JP¥2.86b.

A Look At Nippon Pallet Pool's Liabilities

The latest balance sheet data shows that Nippon Pallet Pool had liabilities of JP¥3.05b due within a year, and liabilities of JP¥2.33b falling due after that. Offsetting these obligations, it had cash of JP¥734.0m as well as receivables valued at JP¥864.0m due within 12 months. So it has liabilities totalling JP¥3.78b more than its cash and near-term receivables, combined.

When you consider that this deficiency exceeds the company's JP¥2.75b market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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).

Nippon Pallet Pool has a low net debt to EBITDA ratio of only 0.89. And its EBIT easily covers its interest expense, being 26.4 times the size. So we're pretty relaxed about its super-conservative use of debt. Also positive, Nippon Pallet Pool grew its EBIT by 25% in the last year, and that should make it easier to pay down debt, going forward. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Nippon Pallet Pool'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Happily for any shareholders, Nippon Pallet Pool actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

Both Nippon Pallet Pool's ability to to cover its interest expense with its EBIT and its conversion of EBIT to free cash flow gave us comfort that it can handle its debt. But truth be told its level of total liabilities had us nibbling our nails. When we consider all the elements mentioned above, it seems to us that Nippon Pallet Pool is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 2 warning signs for Nippon Pallet Pool that you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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