Here's Why Nireco (TYO:6863) Can Manage Its Debt Responsibly

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. As with many other companies Nireco Corporation (TYO:6863) makes use of debt. But the more important question is: how much risk is that debt creating?

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. 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. 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.

View our latest analysis for Nireco

What Is Nireco's Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Nireco had JP¥367.0m of debt, an increase on JP¥16.0m, over one year. However, its balance sheet shows it holds JP¥4.81b in cash, so it actually has JP¥4.45b net cash.

How Healthy Is Nireco's Balance Sheet?

According to the last reported balance sheet, Nireco had liabilities of JP¥1.27b due within 12 months, and liabilities of JP¥541.0m due beyond 12 months. Offsetting these obligations, it had cash of JP¥4.81b as well as receivables valued at JP¥3.04b due within 12 months. So it can boast JP¥6.05b more liquid assets than total liabilities.

This surplus liquidity suggests that Nireco's balance sheet could take a hit just as well as Homer Simpson's head can take a punch. On this view, lenders should feel as safe as the beloved of a black-belt karate master. Simply put, the fact that Nireco has more cash than debt is arguably a good indication that it can manage its debt safely.

On the other hand, Nireco's EBIT dived 19%, over the last year. If that rate of decline in earnings continues, the company could find itself in a tight spot. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Nireco's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. Nireco 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. In the last three years, Nireco's free cash flow amounted to 41% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that Nireco has net cash of JP¥4.45b, as well as more liquid assets than liabilities. So we don't have any problem with Nireco's use of debt. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Be aware that Nireco is showing 2 warning signs in our investment analysis , you should know about...

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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