Wagokoro (TSE:9271) Seems To Use Debt Quite Sensibly

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. Importantly, Wagokoro Co., Ltd. (TSE:9271) does carry debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Wagokoro

What Is Wagokoro's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Wagokoro had JP¥433.0m of debt in September 2024, down from JP¥558.0m, one year before. On the flip side, it has JP¥202.0m in cash leading to net debt of about JP¥231.0m.

A Look At Wagokoro's Liabilities

We can see from the most recent balance sheet that Wagokoro had liabilities of JP¥741.0m falling due within a year, and liabilities of JP¥79.0m due beyond that. On the other hand, it had cash of JP¥202.0m and JP¥259.0m worth of receivables due within a year. So it has liabilities totalling JP¥359.0m more than its cash and near-term receivables, combined.

Of course, Wagokoro has a market capitalization of JP¥3.08b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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.

Wagokoro has a low net debt to EBITDA ratio of only 0.70. And its EBIT easily covers its interest expense, being 63.0 times the size. So we're pretty relaxed about its super-conservative use of debt. Although Wagokoro made a loss at the EBIT level, last year, it was also good to see that it generated JP¥315m in EBIT over the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Wagokoro's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Wagokoro 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

Wagokoro's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered were considerably better. There's no doubt that its ability to to cover its interest expense with its EBIT is pretty flash. When we consider all the factors mentioned above, we do feel a bit cautious about Wagokoro's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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. To that end, you should learn about the 3 warning signs we've spotted with Wagokoro (including 1 which shouldn't be ignored) .

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.