Is Koken Boring MachineLtd (TYO:6297) A Risky Investment?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Koken Boring Machine Co.,Ltd. (TYO:6297) does carry debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Koken Boring MachineLtd

What Is Koken Boring MachineLtd's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2020 Koken Boring MachineLtd had JP¥1.45b of debt, an increase on JP¥1.08b, over one year. However, its balance sheet shows it holds JP¥2.27b in cash, so it actually has JP¥814.0m net cash.

How Healthy Is Koken Boring MachineLtd's Balance Sheet?

We can see from the most recent balance sheet that Koken Boring MachineLtd had liabilities of JP¥3.95b falling due within a year, and liabilities of JP¥1.22b due beyond that. On the other hand, it had cash of JP¥2.27b and JP¥2.17b worth of receivables due within a year. So it has liabilities totalling JP¥730.0m more than its cash and near-term receivables, combined.

Since publicly traded Koken Boring MachineLtd shares are worth a total of JP¥5.17b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. Despite its noteworthy liabilities, Koken Boring MachineLtd boasts net cash, so it's fair to say it does not have a heavy debt load!

On the other hand, Koken Boring MachineLtd saw its EBIT drop by 8.0% in the last twelve months. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. There's no doubt that we learn most about debt from the balance sheet. But it is Koken Boring MachineLtd's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. While Koken Boring MachineLtd has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last three years, Koken Boring MachineLtd saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Summing up

While Koken Boring MachineLtd does have more liabilities than liquid assets, it also has net cash of JP¥814.0m. So although we see some areas for improvement, we're not too worried about Koken Boring MachineLtd's balance sheet. 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. Be aware that Koken Boring MachineLtd is showing 3 warning signs in our investment analysis , you should know about...

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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