Does Kawasaki Heavy Industries (TSE:7012) Have A Healthy Balance Sheet?

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.' 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. Importantly, Kawasaki Heavy Industries, Ltd. (TSE:7012) does carry debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Kawasaki Heavy Industries

What Is Kawasaki Heavy Industries's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2024 Kawasaki Heavy Industries had debt of JP¥979.8b, up from JP¥852.6b in one year. However, because it has a cash reserve of JP¥127.4b, its net debt is less, at about JP¥852.4b.

How Healthy Is Kawasaki Heavy Industries' Balance Sheet?

The latest balance sheet data shows that Kawasaki Heavy Industries had liabilities of JP¥1.72t due within a year, and liabilities of JP¥436.9b falling due after that. Offsetting this, it had JP¥127.4b in cash and JP¥572.3b in receivables that were due within 12 months. So its liabilities total JP¥1.46t more than the combination of its cash and short-term receivables.

Given this deficit is actually higher than the company's market capitalization of JP¥1.05t, we think shareholders really should watch Kawasaki Heavy Industries's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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

Kawasaki Heavy Industries's debt is 4.4 times its EBITDA, and its EBIT cover its interest expense 4.1 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. However, it should be some comfort for shareholders to recall that Kawasaki Heavy Industries actually grew its EBIT by a hefty 963%, over the last 12 months. If it can keep walking that path it will be in a position to shed its debt with relative ease. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Kawasaki Heavy Industries'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.

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. In the last three years, Kawasaki Heavy Industries created free cash flow amounting to 5.4% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

On the face of it, Kawasaki Heavy Industries's conversion of EBIT to free cash flow left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Looking at the bigger picture, it seems clear to us that Kawasaki Heavy Industries's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. 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. Case in point: We've spotted 3 warning signs for Kawasaki Heavy Industries you should be aware of, and 1 of them is potentially serious.

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.