Kubota (TSE:6326) Takes On Some Risk With Its Use Of Debt

Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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. We note that Kubota Corporation (TSE:6326) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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 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. 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.

Check out our latest analysis for Kubota

What Is Kubota's Net Debt?

As you can see below, at the end of June 2024, Kubota had JP¥2.26t of debt, up from JP¥1.94t a year ago. Click the image for more detail. However, it does have JP¥400.3b in cash offsetting this, leading to net debt of about JP¥1.86t.

A Look At Kubota's Liabilities

Zooming in on the latest balance sheet data, we can see that Kubota had liabilities of JP¥1.71t due within 12 months and liabilities of JP¥1.58t due beyond that. Offsetting these obligations, it had cash of JP¥400.3b as well as receivables valued at JP¥1.76t due within 12 months. So its liabilities total JP¥1.14t more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Kubota has a huge market capitalization of JP¥2.37t, 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.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Kubota's net debt is 4.3 times its EBITDA, which is a significant but still reasonable amount of leverage. However, its interest coverage of 1k is very high, suggesting that the interest expense on the debt is currently quite low. Also relevant is that Kubota has grown its EBIT by a very respectable 28% in the last year, thus enhancing its ability to pay down debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Kubota's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Kubota saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

We feel some trepidation about Kubota's difficulty conversion of EBIT to free cash flow, but we've got positives to focus on, too. To wit both its interest cover and EBIT growth rate were encouraging signs. Looking at all the angles mentioned above, it does seem to us that Kubota is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Kubota (of which 1 shouldn't be ignored!) you should know about.

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.