Sumitomo Heavy Industries (TSE:6302) Has A Somewhat Strained Balance Sheet

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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Sumitomo Heavy Industries, Ltd. (TSE:6302) does carry debt. But the real question is whether this debt is making the company risky.

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. If things get really bad, the lenders can take control of the business. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Sumitomo Heavy Industries

What Is Sumitomo Heavy Industries's Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2024 Sumitomo Heavy Industries had JP¥225.2b of debt, an increase on JP¥162.2b, over one year. However, it does have JP¥107.4b in cash offsetting this, leading to net debt of about JP¥117.8b.

How Healthy Is Sumitomo Heavy Industries' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Sumitomo Heavy Industries had liabilities of JP¥407.2b due within 12 months and liabilities of JP¥185.9b due beyond that. Offsetting this, it had JP¥107.4b in cash and JP¥255.8b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by JP¥229.9b.

This deficit is considerable relative to its market capitalization of JP¥381.3b, so it does suggest shareholders should keep an eye on Sumitomo Heavy Industries' use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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). 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).

Sumitomo Heavy Industries's net debt is only 1.1 times its EBITDA. And its EBIT easily covers its interest expense, being 74.6 times the size. So we're pretty relaxed about its super-conservative use of debt. But the other side of the story is that Sumitomo Heavy Industries saw its EBIT decline by 7.1% over the last year. That sort of decline, if sustained, will obviously make debt harder to handle. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Sumitomo Heavy Industries'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. Over the last three years, Sumitomo Heavy Industries barely recorded positive free cash flow, in total. While many companies do operate at break-even, we prefer see substantial free cash flow, especially if a it already has dead.

Our View

Sumitomo Heavy Industries's conversion of EBIT to free cash flow and EBIT growth rate definitely weigh on it, in our esteem. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. Taking the abovementioned factors together we do think Sumitomo Heavy Industries's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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 - Sumitomo Heavy Industries has 2 warning signs we think you should be aware of.

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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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.