Stock Analysis
Is Kyokuto Kaihatsu KogyoLtd (TSE:7226) Using Too Much Debt?
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.' 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 Kyokuto Kaihatsu Kogyo Co.,Ltd. (TSE:7226) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.
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What Is Kyokuto Kaihatsu KogyoLtd's Net Debt?
The image below, which you can click on for greater detail, shows that at June 2024 Kyokuto Kaihatsu KogyoLtd had debt of JP¥18.6b, up from JP¥11.3b in one year. But it also has JP¥21.7b in cash to offset that, meaning it has JP¥3.11b net cash.
How Strong Is Kyokuto Kaihatsu KogyoLtd's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Kyokuto Kaihatsu KogyoLtd had liabilities of JP¥33.3b due within 12 months and liabilities of JP¥18.3b due beyond that. Offsetting this, it had JP¥21.7b in cash and JP¥36.5b in receivables that were due within 12 months. So it actually has JP¥6.58b more liquid assets than total liabilities.
This short term liquidity is a sign that Kyokuto Kaihatsu KogyoLtd could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Kyokuto Kaihatsu KogyoLtd has more cash than debt is arguably a good indication that it can manage its debt safely.
Better yet, Kyokuto Kaihatsu KogyoLtd grew its EBIT by 511% last year, which is an impressive improvement. If maintained that growth will make the debt even more manageable in the years ahead. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Kyokuto Kaihatsu KogyoLtd 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. Kyokuto Kaihatsu KogyoLtd may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last three years, Kyokuto Kaihatsu KogyoLtd 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.
Summing Up
While it is always sensible to investigate a company's debt, in this case Kyokuto Kaihatsu KogyoLtd has JP¥3.11b in net cash and a decent-looking balance sheet. And we liked the look of last year's 511% year-on-year EBIT growth. So we don't have any problem with Kyokuto Kaihatsu KogyoLtd's use of debt. 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 example, we've discovered 2 warning signs for Kyokuto Kaihatsu KogyoLtd (1 is concerning!) that you should be aware of before investing here.
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.
About TSE:7226
Kyokuto Kaihatsu KogyoLtd
Manufactures and sells special purpose vehicles, environmental equipment and systems, and car parking systems in Japan.