Is KyowakogyosyoLtd (TYO:5971) Using Too Much Debt?

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. Importantly, Kyowakogyosyo Co.,Ltd. (TYO:5971) does carry debt. But the real question is whether this debt is making the company risky.

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. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for KyowakogyosyoLtd

What Is KyowakogyosyoLtd's Net Debt?

You can click the graphic below for the historical numbers, but it shows that KyowakogyosyoLtd had JP¥302.0m of debt in October 2020, down from JP¥554.0m, one year before. However, it does have JP¥6.37b in cash offsetting this, leading to net cash of JP¥6.07b.

How Strong Is KyowakogyosyoLtd's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that KyowakogyosyoLtd had liabilities of JP¥1.09b due within 12 months and liabilities of JP¥617.0m due beyond that. On the other hand, it had cash of JP¥6.37b and JP¥1.92b worth of receivables due within a year. So it actually has JP¥6.58b more liquid assets than total liabilities.

This luscious liquidity implies that KyowakogyosyoLtd's balance sheet is sturdy like a giant sequoia tree. On this view, lenders should feel as safe as the beloved of a black-belt karate master. Simply put, the fact that KyowakogyosyoLtd has more cash than debt is arguably a good indication that it can manage its debt safely.

It is just as well that KyowakogyosyoLtd's load is not too heavy, because its EBIT was down 84% over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. There's no doubt that we learn most about debt from the balance sheet. But it is KyowakogyosyoLtd'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. KyowakogyosyoLtd 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. Over the most recent three years, KyowakogyosyoLtd recorded free cash flow worth 79% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Summing up

While we empathize with investors who find debt concerning, the bottom line is that KyowakogyosyoLtd has net cash of JP¥6.07b and plenty of liquid assets. The cherry on top was that in converted 79% of that EBIT to free cash flow, bringing in JP¥442m. So we don't think KyowakogyosyoLtd's use of debt is risky. 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. To that end, you should be aware of the 2 warning signs we've spotted with KyowakogyosyoLtd .

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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