Kitagawa SeikiLtd (TYO:6327) Could Easily Take On More Debt

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 Kitagawa Seiki Co.,Ltd. (TYO:6327) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt 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¥1.59b of debt at December 2020, down from JP¥1.82b a year prior. However, because it has a cash reserve of JP¥1.17b, its net debt is less, at about JP¥417.0m.

A Look At Kitagawa SeikiLtd's Liabilities

We can see from the most recent balance sheet that Kitagawa SeikiLtd had liabilities of JP¥2.32b falling due within a year, and liabilities of JP¥933.0m due beyond that. Offsetting this, it had JP¥1.17b in cash and JP¥1.45b in receivables that were due within 12 months. So its liabilities total JP¥628.0m more than the combination of its cash and short-term receivables.

Of course, Kitagawa SeikiLtd has a market capitalization of JP¥4.79b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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). 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).

Kitagawa SeikiLtd's net debt is only 0.55 times its EBITDA. And its EBIT easily covers its interest expense, being 25.9 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On top of that, Kitagawa SeikiLtd grew its EBIT by 32% over the last twelve months, and that growth will make it easier to handle its debt. 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 it's worth checking how much of that EBIT is backed by free cash flow. Over the most recent three years, Kitagawa SeikiLtd recorded free cash flow worth 68% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

The good news is that Kitagawa SeikiLtd's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And the good news does not stop there, as its EBIT growth rate also supports that impression! Considering this range of factors, it seems to us that Kitagawa SeikiLtd is quite prudent with its debt, and the risks seem well managed. So the balance sheet looks pretty healthy, to us. 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. We've identified 3 warning signs with Kitagawa SeikiLtd (at least 2 which are potentially serious) , and understanding them should be part of your investment process.

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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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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