These 4 Measures Indicate That Kozo Keikaku Engineering (TYO:4748) Is Using Debt Reasonably Well

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. We note that Kozo Keikaku Engineering Inc. (TYO:4748) 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 assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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.

See our latest analysis for Kozo Keikaku Engineering

How Much Debt Does Kozo Keikaku Engineering Carry?

As you can see below, at the end of September 2020, Kozo Keikaku Engineering had JP¥3.20b of debt, up from JP¥2.84b a year ago. Click the image for more detail. However, it also had JP¥956.0m in cash, and so its net debt is JP¥2.24b.

How Healthy Is Kozo Keikaku Engineering's Balance Sheet?

We can see from the most recent balance sheet that Kozo Keikaku Engineering had liabilities of JP¥4.20b falling due within a year, and liabilities of JP¥4.09b due beyond that. Offsetting this, it had JP¥956.0m in cash and JP¥1.06b in receivables that were due within 12 months. So its liabilities total JP¥6.27b more than the combination of its cash and short-term receivables.

Kozo Keikaku Engineering has a market capitalization of JP¥13.3b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Kozo Keikaku Engineering's net debt is only 1.3 times its EBITDA. And its EBIT covers its interest expense a whopping 135 times over. So we're pretty relaxed about its super-conservative use of debt. On the other hand, Kozo Keikaku Engineering's EBIT dived 11%, over the last year. If that rate of decline in earnings continues, the company could find itself in a tight spot. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Kozo Keikaku Engineering 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Kozo Keikaku Engineering produced sturdy free cash flow equating to 76% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Kozo Keikaku Engineering's interest cover was a real positive on this analysis, as was its conversion of EBIT to free cash flow. Having said that, its EBIT growth rate somewhat sensitizes us to potential future risks to the balance sheet. When we consider all the elements mentioned above, it seems to us that Kozo Keikaku Engineering is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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. Take risks, for example - Kozo Keikaku Engineering has 2 warning signs we think you should be aware of.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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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