Stock Analysis

Komatsu (TSE:6301) Seems To Use Debt Quite Sensibly

TSE:6301
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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.' 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 Komatsu Ltd. (TSE:6301) does use debt in its business. But should shareholders be worried about its use of debt?

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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

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How Much Debt Does Komatsu Carry?

The chart below, which you can click on for greater detail, shows that Komatsu had JP¥1.21t in debt in December 2023; about the same as the year before. However, because it has a cash reserve of JP¥346.7b, its net debt is less, at about JP¥863.3b.

debt-equity-history-analysis
TSE:6301 Debt to Equity History March 23rd 2024

How Strong Is Komatsu's Balance Sheet?

According to the last reported balance sheet, Komatsu had liabilities of JP¥1.52t due within 12 months, and liabilities of JP¥857.6b due beyond 12 months. Offsetting this, it had JP¥346.7b in cash and JP¥1.13t in receivables that were due within 12 months. So it has liabilities totalling JP¥906.2b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Komatsu is worth a massive JP¥4.26t, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Komatsu's net debt is only 1.1 times its EBITDA. And its EBIT covers its interest expense a whopping 16.9 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. In addition to that, we're happy to report that Komatsu has boosted its EBIT by 41%, thus reducing the spectre of future debt repayments. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Komatsu'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. So it's worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent three years, Komatsu recorded free cash flow of 26% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Happily, Komatsu's impressive interest cover implies it has the upper hand on its debt. But truth be told we feel its conversion of EBIT to free cash flow does undermine this impression a bit. Taking all this data into account, it seems to us that Komatsu takes a pretty sensible approach to debt. While that brings some risk, it can also enhance returns for shareholders. 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 example, we've discovered 1 warning sign for Komatsu that you should be aware of before investing here.

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.

Valuation is complex, but we're here to simplify it.

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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.