Is Toyo Denki Seizo K.K (TSE:6505) Using Too Much Debt?

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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Toyo Denki Seizo K.K. (TSE:6505) makes use of debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Toyo Denki Seizo K.K

What Is Toyo Denki Seizo K.K's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Toyo Denki Seizo K.K had JP¥10.6b of debt in May 2024, down from JP¥11.2b, one year before. However, because it has a cash reserve of JP¥6.42b, its net debt is less, at about JP¥4.17b.

How Strong Is Toyo Denki Seizo K.K's Balance Sheet?

According to the last reported balance sheet, Toyo Denki Seizo K.K had liabilities of JP¥15.2b due within 12 months, and liabilities of JP¥10.3b due beyond 12 months. Offsetting this, it had JP¥6.42b in cash and JP¥13.7b in receivables that were due within 12 months. So it has liabilities totalling JP¥5.46b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Toyo Denki Seizo K.K is worth JP¥9.79b, 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Toyo Denki Seizo K.K's net debt to EBITDA ratio of about 2.5 suggests only moderate use of debt. And its commanding EBIT of 1k times its interest expense, implies the debt load is as light as a peacock feather. Importantly, Toyo Denki Seizo K.K grew its EBIT by 79% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Toyo Denki Seizo K.K will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

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, Toyo Denki Seizo K.K actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

Happily, Toyo Denki Seizo K.K's impressive interest cover implies it has the upper hand on its debt. But truth be told we feel its level of total liabilities does undermine this impression a bit. Looking at the bigger picture, we think Toyo Denki Seizo K.K's use of debt seems quite reasonable and we're not concerned about it. While debt does bring risk, when used wisely it can also bring a higher return on equity. 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. For example Toyo Denki Seizo K.K has 3 warning signs (and 1 which can't be ignored) we think you should know about.

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.