Stock Analysis

We Think DAIHEN (TSE:6622) Is Taking Some Risk With Its Debt

TSE:6622
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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 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. As with many other companies DAIHEN Corporation (TSE:6622) makes use of debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for DAIHEN

How Much Debt Does DAIHEN Carry?

The image below, which you can click on for greater detail, shows that at December 2023 DAIHEN had debt of JP¥56.0b, up from JP¥35.6b in one year. However, it also had JP¥18.3b in cash, and so its net debt is JP¥37.7b.

debt-equity-history-analysis
TSE:6622 Debt to Equity History March 21st 2024

How Healthy Is DAIHEN's Balance Sheet?

We can see from the most recent balance sheet that DAIHEN had liabilities of JP¥71.6b falling due within a year, and liabilities of JP¥37.9b due beyond that. Offsetting these obligations, it had cash of JP¥18.3b as well as receivables valued at JP¥41.6b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by JP¥49.6b.

While this might seem like a lot, it is not so bad since DAIHEN has a market capitalization of JP¥229.7b, 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 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

DAIHEN's net debt to EBITDA ratio of about 2.1 suggests only moderate use of debt. And its commanding EBIT of 3k times its interest expense, implies the debt load is as light as a peacock feather. Unfortunately, DAIHEN's EBIT flopped 15% over the last four quarters. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if DAIHEN can strengthen its balance sheet over time. 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 always check how much of that EBIT is translated into free cash flow. Over the last three years, DAIHEN 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

Mulling over DAIHEN's attempt at converting EBIT to free cash flow, we're certainly not enthusiastic. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Once we consider all the factors above, together, it seems to us that DAIHEN's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for DAIHEN you should know about.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.