Is Kyowa Engineering ConsultantsLtd (TYO:9647) Using Too Much Debt?

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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Kyowa Engineering Consultants Co.,Ltd. (TYO:9647) makes use of debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Kyowa Engineering ConsultantsLtd

How Much Debt Does Kyowa Engineering ConsultantsLtd Carry?

The chart below, which you can click on for greater detail, shows that Kyowa Engineering ConsultantsLtd had JP¥2.13b in debt in November 2020; about the same as the year before. But it also has JP¥3.12b in cash to offset that, meaning it has JP¥993.0m net cash.

How Healthy Is Kyowa Engineering ConsultantsLtd's Balance Sheet?

According to the last reported balance sheet, Kyowa Engineering ConsultantsLtd had liabilities of JP¥3.76b due within 12 months, and liabilities of JP¥925.0m due beyond 12 months. Offsetting this, it had JP¥3.12b in cash and JP¥934.0m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by JP¥636.0m.

While this might seem like a lot, it is not so bad since Kyowa Engineering ConsultantsLtd has a market capitalization of JP¥1.99b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. Despite its noteworthy liabilities, Kyowa Engineering ConsultantsLtd boasts net cash, so it's fair to say it does not have a heavy debt load!

Also good is that Kyowa Engineering ConsultantsLtd grew its EBIT at 19% over the last year, further increasing its ability to manage debt. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Kyowa Engineering ConsultantsLtd 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. Kyowa Engineering ConsultantsLtd 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 last three years, Kyowa Engineering ConsultantsLtd actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Summing up

Although Kyowa Engineering ConsultantsLtd's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of JP¥993.0m. The cherry on top was that in converted 170% of that EBIT to free cash flow, bringing in JP¥663m. So we don't think Kyowa Engineering ConsultantsLtd's use of debt is risky. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 3 warning signs with Kyowa Engineering ConsultantsLtd , and understanding them should be part of your investment process.

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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