Here's Why Sanso ElectricLtd (TYO:6518) Can Manage Its Debt Responsibly

Warren Buffett famously said, '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. We can see that Sanso Electric Co.,Ltd. (TYO:6518) does use debt in its business. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. 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. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Sanso ElectricLtd

What Is Sanso ElectricLtd's Net Debt?

The image below, which you can click on for greater detail, shows that Sanso ElectricLtd had debt of JP¥1.49b at the end of December 2020, a reduction from JP¥1.83b over a year. But it also has JP¥2.77b in cash to offset that, meaning it has JP¥1.28b net cash.

How Healthy Is Sanso ElectricLtd's Balance Sheet?

According to the last reported balance sheet, Sanso ElectricLtd had liabilities of JP¥3.98b due within 12 months, and liabilities of JP¥2.40b due beyond 12 months. Offsetting this, it had JP¥2.77b in cash and JP¥4.48b in receivables that were due within 12 months. So it actually has JP¥874.0m more liquid assets than total liabilities.

This excess liquidity suggests that Sanso ElectricLtd is taking a careful approach to debt. Given it has easily adequate short term liquidity, we don't think it will have any issues with its lenders. Simply put, the fact that Sanso ElectricLtd has more cash than debt is arguably a good indication that it can manage its debt safely.

On the other hand, Sanso ElectricLtd's EBIT dived 10%, over the last year. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Sanso ElectricLtd will need earnings to service that debt. 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Sanso ElectricLtd 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, Sanso ElectricLtd recorded free cash flow worth 76% 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.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that Sanso ElectricLtd has net cash of JP¥1.28b, as well as more liquid assets than liabilities. The cherry on top was that in converted 76% of that EBIT to free cash flow, bringing in JP¥485m. So is Sanso ElectricLtd's debt a risk? It doesn't seem so 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. To that end, you should learn about the 2 warning signs we've spotted with Sanso ElectricLtd (including 1 which shouldn't be ignored) .

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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