Stock Analysis

We Think NSK (TSE:6471) Is Taking Some Risk With Its Debt

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TSE:6471

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 note that NSK Ltd. (TSE:6471) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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 examine debt levels, we first consider both cash and debt levels, together.

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How Much Debt Does NSK Carry?

You can click the graphic below for the historical numbers, but it shows that NSK had JP¥318.9b of debt in March 2024, down from JP¥335.7b, one year before. However, it also had JP¥195.7b in cash, and so its net debt is JP¥123.3b.

TSE:6471 Debt to Equity History July 27th 2024

A Look At NSK's Liabilities

The latest balance sheet data shows that NSK had liabilities of JP¥347.8b due within a year, and liabilities of JP¥272.3b falling due after that. Offsetting these obligations, it had cash of JP¥195.7b as well as receivables valued at JP¥225.2b due within 12 months. So its liabilities total JP¥199.2b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since NSK has a market capitalization of JP¥379.8b, 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.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

NSK's net debt to EBITDA ratio of about 1.6 suggests only moderate use of debt. And its strong interest cover of 11.4 times, makes us even more comfortable. In fact NSK's saving grace is its low debt levels, because its EBIT has tanked 25% in the last twelve months. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine NSK'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, NSK's free cash flow amounted to 49% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

NSK's struggle to grow its EBIT had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. In particular, its interest cover was re-invigorating. When we consider all the factors discussed, it seems to us that NSK is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 1 warning sign for NSK that you should be aware of.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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.