Is Kitagawa SeikiLtd (TYO:6327) 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.' 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 Kitagawa Seiki Co.,Ltd. (TYO:6327) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Kitagawa SeikiLtd

What Is Kitagawa SeikiLtd's Net Debt?

As you can see below, Kitagawa SeikiLtd had JP¥1.62b of debt at September 2020, down from JP¥1.84b a year prior. However, because it has a cash reserve of JP¥1.52b, its net debt is less, at about JP¥97.0m.

How Healthy Is Kitagawa SeikiLtd's Balance Sheet?

The latest balance sheet data shows that Kitagawa SeikiLtd had liabilities of JP¥3.66b due within a year, and liabilities of JP¥952.0m falling due after that. Offsetting this, it had JP¥1.52b in cash and JP¥1.16b in receivables that were due within 12 months. So it has liabilities totalling JP¥1.93b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Kitagawa SeikiLtd is worth JP¥4.18b, and thus could probably raise enough capital to shore up 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 use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Kitagawa SeikiLtd's net debt is only 0.19 times its EBITDA. And its EBIT covers its interest expense a whopping 15.0 times over. So we're pretty relaxed about its super-conservative use of debt. The modesty of its debt load may become crucial for Kitagawa SeikiLtd if management cannot prevent a repeat of the 34% cut to EBIT over the last year. 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 you can't view debt in total isolation; since Kitagawa SeikiLtd 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Kitagawa SeikiLtd actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

Based on what we've seen Kitagawa SeikiLtd is not finding it easy, given its EBIT growth rate, but the other factors we considered give us cause to be optimistic. There's no doubt that its ability to to cover its interest expense with its EBIT is pretty flash. Considering this range of data points, we think Kitagawa SeikiLtd is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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 Kitagawa SeikiLtd .

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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