Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Asahi Rubber Inc. (TYO:5162) does have debt on its balance sheet. But is this debt a concern to shareholders?
When Is Debt A Problem?
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. If things get really bad, the lenders can take control of the business. 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.
Check out our latest analysis for Asahi Rubber
What Is Asahi Rubber's Debt?
You can click the graphic below for the historical numbers, but it shows that as of September 2020 Asahi Rubber had JP¥3.80b of debt, an increase on JP¥3.26b, over one year. On the flip side, it has JP¥3.10b in cash leading to net debt of about JP¥701.0m.
How Strong Is Asahi Rubber's Balance Sheet?
According to the last reported balance sheet, Asahi Rubber had liabilities of JP¥2.74b due within 12 months, and liabilities of JP¥3.35b due beyond 12 months. Offsetting this, it had JP¥3.10b in cash and JP¥1.53b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by JP¥1.46b.
This deficit isn't so bad because Asahi Rubber is worth JP¥3.21b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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).
Asahi Rubber has a low net debt to EBITDA ratio of only 1.2. And its EBIT covers its interest expense a whopping 48.0 times over. So we're pretty relaxed about its super-conservative use of debt. The modesty of its debt load may become crucial for Asahi Rubber if management cannot prevent a repeat of the 84% cut to EBIT over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Asahi Rubber's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Asahi Rubber recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.
Our View
On the face of it, Asahi Rubber's conversion of EBIT to free cash flow left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Once we consider all the factors above, together, it seems to us that Asahi Rubber's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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 example Asahi Rubber has 3 warning signs (and 1 which is potentially serious) we think you should know about.
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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About TSE:5162
Flawless balance sheet established dividend payer.
