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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Trusco Nakayama Corporation (TSE:9830) does use debt in its business. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
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. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.
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What Is Trusco Nakayama's Net Debt?
As you can see below, at the end of June 2024, Trusco Nakayama had JP¥56.5b of debt, up from JP¥45.0b a year ago. Click the image for more detail. However, because it has a cash reserve of JP¥40.8b, its net debt is less, at about JP¥15.7b.
A Look At Trusco Nakayama's Liabilities
According to the last reported balance sheet, Trusco Nakayama had liabilities of JP¥39.6b due within 12 months, and liabilities of JP¥47.9b due beyond 12 months. Offsetting this, it had JP¥40.8b in cash and JP¥37.5b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by JP¥9.27b.
Of course, Trusco Nakayama has a market capitalization of JP¥156.6b, 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Trusco Nakayama's net debt is only 0.63 times its EBITDA. And its EBIT covers its interest expense a whopping 277 times over. So we're pretty relaxed about its super-conservative use of debt. Fortunately, Trusco Nakayama grew its EBIT by 6.7% in the last year, making that debt load look even more manageable. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Trusco Nakayama's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Trusco Nakayama reported free cash flow worth 5.9% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.
Our View
The good news is that Trusco Nakayama's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But we must concede we find its conversion of EBIT to free cash flow has the opposite effect. All these things considered, it appears that Trusco Nakayama can comfortably handle its current debt levels. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example - Trusco Nakayama has 1 warning sign we think you should be aware of.
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.
About TSE:9830
Trusco Nakayama
Engages in the wholesale of machine tools, distribution equipment, and environmental safety equipment in Japan and internationally.
Adequate balance sheet with moderate growth potential.