Does Penta-Ocean Construction (TSE:1893) Have A Healthy Balance Sheet?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. We can see that Penta-Ocean Construction Co., Ltd. (TSE:1893) does use debt in its business. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Penta-Ocean Construction

What Is Penta-Ocean Construction's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2023 Penta-Ocean Construction had JP¥198.0b of debt, an increase on JP¥142.4b, over one year. On the flip side, it has JP¥49.1b in cash leading to net debt of about JP¥148.9b.

How Strong Is Penta-Ocean Construction's Balance Sheet?

According to the last reported balance sheet, Penta-Ocean Construction had liabilities of JP¥381.6b due within 12 months, and liabilities of JP¥64.9b due beyond 12 months. Offsetting these obligations, it had cash of JP¥49.1b as well as receivables valued at JP¥380.6b due within 12 months. So its liabilities total JP¥16.8b more than the combination of its cash and short-term receivables.

Of course, Penta-Ocean Construction has a market capitalization of JP¥217.0b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Penta-Ocean Construction has a debt to EBITDA ratio of 3.7, which signals significant debt, but is still pretty reasonable for most types of business. However, its interest coverage of 42.0 is very high, suggesting that the interest expense on the debt is currently quite low. Notably, Penta-Ocean Construction made a loss at the EBIT level, last year, but improved that to positive EBIT of JP¥32b in the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Penta-Ocean Construction can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. During the last year, Penta-Ocean Construction burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

Neither Penta-Ocean Construction's ability to convert EBIT to free cash flow nor its net debt to EBITDA gave us confidence in its ability to take on more debt. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. Looking at all the angles mentioned above, it does seem to us that Penta-Ocean Construction is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. Be aware that Penta-Ocean Construction is showing 2 warning signs in our investment analysis , and 1 of those is a bit unpleasant...

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.