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. Importantly, Seiwa Chuo Holdings Corporation (TYO:7531) does carry 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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Seiwa Chuo Holdings Carry?
The image below, which you can click on for greater detail, shows that Seiwa Chuo Holdings had debt of JP¥680.0m at the end of December 2020, a reduction from JP¥3.01b over a year. But it also has JP¥1.34b in cash to offset that, meaning it has JP¥662.0m net cash.
A Look At Seiwa Chuo Holdings' Liabilities
We can see from the most recent balance sheet that Seiwa Chuo Holdings had liabilities of JP¥11.6b falling due within a year, and liabilities of JP¥1.44b due beyond that. On the other hand, it had cash of JP¥1.34b and JP¥11.3b worth of receivables due within a year. So its liabilities total JP¥374.0m more than the combination of its cash and short-term receivables.
Of course, Seiwa Chuo Holdings has a market capitalization of JP¥10.6b, 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. While it does have liabilities worth noting, Seiwa Chuo Holdings also has more cash than debt, so we're pretty confident it can manage its debt safely.
It is just as well that Seiwa Chuo Holdings's load is not too heavy, because its EBIT was down 80% over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Seiwa Chuo Holdings 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Seiwa Chuo Holdings 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. Happily for any shareholders, Seiwa Chuo Holdings actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
We could understand if investors are concerned about Seiwa Chuo Holdings's liabilities, but we can be reassured by the fact it has has net cash of JP¥662.0m. And it impressed us with free cash flow of JP¥2.4b, being 135% of its EBIT. So we don't have any problem with Seiwa Chuo Holdings'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. For instance, we've identified 4 warning signs for Seiwa Chuo Holdings (1 is a bit concerning) you should be aware of.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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