Is Amita HoldingsLtd (TYO:2195) Using Too Much Debt?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. We can see that Amita Holdings Co.,Ltd. (TYO:2195) does use debt in its business. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. 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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Amita HoldingsLtd

What Is Amita HoldingsLtd's Debt?

As you can see below, Amita HoldingsLtd had JP¥1.50b of debt at September 2020, down from JP¥1.87b a year prior. However, because it has a cash reserve of JP¥912.0m, its net debt is less, at about JP¥589.0m.

How Strong Is Amita HoldingsLtd's Balance Sheet?

We can see from the most recent balance sheet that Amita HoldingsLtd had liabilities of JP¥1.68b falling due within a year, and liabilities of JP¥1.45b due beyond that. On the other hand, it had cash of JP¥912.0m and JP¥532.0m worth of receivables due within a year. So its liabilities total JP¥1.68b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Amita HoldingsLtd has a market capitalization of JP¥3.51b, 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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Amita HoldingsLtd has a low net debt to EBITDA ratio of only 1.4. And its EBIT covers its interest expense a whopping 12.7 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. While Amita HoldingsLtd doesn't seem to have gained much on the EBIT line, at least earnings remain stable for now. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Amita HoldingsLtd will need earnings to service that debt. 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 company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Amita HoldingsLtd generated free cash flow amounting to a very robust 99% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Our View

Happily, Amita HoldingsLtd's impressive interest cover implies it has the upper hand on its debt. But, on a more sombre note, we are a little concerned by its level of total liabilities. All these things considered, it appears that Amita HoldingsLtd 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. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Consider risks, for instance. Every company has them, and we've spotted 2 warning signs for Amita HoldingsLtd you should know about.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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