Here's Why Shinpo (TYO:5903) Can Manage Its Debt Responsibly

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 Shinpo Co., Ltd. (TYO:5903) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Shinpo

What Is Shinpo's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Shinpo had JP¥222.0m of debt, an increase on JP¥50.0m, over one year. However, it does have JP¥2.46b in cash offsetting this, leading to net cash of JP¥2.23b.

A Look At Shinpo's Liabilities

Zooming in on the latest balance sheet data, we can see that Shinpo had liabilities of JP¥672.0m due within 12 months and liabilities of JP¥495.0m due beyond that. Offsetting these obligations, it had cash of JP¥2.46b as well as receivables valued at JP¥535.0m due within 12 months. So it actually has JP¥1.82b more liquid assets than total liabilities.

This surplus suggests that Shinpo is using debt in a way that is appears to be both safe and conservative. Because it has plenty of assets, it is unlikely to have trouble with its lenders. Simply put, the fact that Shinpo has more cash than debt is arguably a good indication that it can manage its debt safely.

In fact Shinpo's saving grace is its low debt levels, because its EBIT has tanked 33% in the last twelve months. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Shinpo can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Shinpo may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. In the last three years, Shinpo created free cash flow amounting to 9.4% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Summing up

While it is always sensible to investigate a company's debt, in this case Shinpo has JP¥2.23b in net cash and a decent-looking balance sheet. So we are not troubled with Shinpo's debt use. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Take risks, for example - Shinpo has 2 warning signs we think 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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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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