Is No.1Ltd (TYO:3562) A Risky Investment?

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. As with many other companies No.1 Co.,Ltd (TYO:3562) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for No.1Ltd

How Much Debt Does No.1Ltd Carry?

As you can see below, at the end of November 2020, No.1Ltd had JP¥1.76b of debt, up from JP¥120.0m a year ago. Click the image for more detail. On the flip side, it has JP¥1.73b in cash leading to net debt of about JP¥33.0m.

A Look At No.1Ltd's Liabilities

Zooming in on the latest balance sheet data, we can see that No.1Ltd had liabilities of JP¥2.46b due within 12 months and liabilities of JP¥1.56b due beyond that. On the other hand, it had cash of JP¥1.73b and JP¥1.84b worth of receivables due within a year. So it has liabilities totalling JP¥452.0m more than its cash and near-term receivables, combined.

Given No.1Ltd has a market capitalization of JP¥8.80b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. But either way, No.1Ltd has virtually no net debt, so it's fair to say it does not have a heavy debt load!

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

No.1Ltd has very little debt (net of cash), and boasts a debt to EBITDA ratio of 0.049 and EBIT of 83.7 times the interest expense. So relative to past earnings, the debt load seems trivial. In addition to that, we're happy to report that No.1Ltd has boosted its EBIT by 71%, thus reducing the spectre of future debt repayments. There's no doubt that we learn most about debt from the balance sheet. But it is No.1Ltd'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 company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, No.1Ltd's free cash flow amounted to 28% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

The good news is that No.1Ltd's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But, on a more sombre note, we are a little concerned by its conversion of EBIT to free cash flow. Looking at the bigger picture, we think No.1Ltd's use of debt seems quite reasonable and we're not concerned about it. After all, sensible leverage can boost returns on equity. 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. Be aware that No.1Ltd is showing 4 warning signs in our investment analysis , and 1 of those doesn't sit too well with us...

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. 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.
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