TOSNET (TYO:4754) Seems To Use Debt Rather Sparingly

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 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. As with many other companies TOSNET Corporation (TYO:4754) makes use of debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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.

Check out our latest analysis for TOSNET

What Is TOSNET's Net Debt?

The image below, which you can click on for greater detail, shows that TOSNET had debt of JP¥872.0m at the end of December 2020, a reduction from JP¥1.10b over a year. But on the other hand it also has JP¥4.27b in cash, leading to a JP¥3.40b net cash position.

A Look At TOSNET's Liabilities

The latest balance sheet data shows that TOSNET had liabilities of JP¥2.05b due within a year, and liabilities of JP¥884.0m falling due after that. Offsetting these obligations, it had cash of JP¥4.27b as well as receivables valued at JP¥1.20b due within 12 months. So it actually has JP¥2.54b more liquid assets than total liabilities.

This surplus liquidity suggests that TOSNET's balance sheet could take a hit just as well as Homer Simpson's head can take a punch. Having regard to this fact, we think its balance sheet is as strong as an ox. Simply put, the fact that TOSNET has more cash than debt is arguably a good indication that it can manage its debt safely.

It is just as well that TOSNET's load is not too heavy, because its EBIT was down 56% over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since TOSNET 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 company can only pay off debt with cold hard cash, not accounting profits. TOSNET 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, TOSNET recorded free cash flow worth a fulsome 81% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Summing up

While it is always sensible to investigate a company's debt, in this case TOSNET has JP¥3.40b in net cash and a decent-looking balance sheet. The cherry on top was that in converted 81% of that EBIT to free cash flow, bringing in JP¥543m. So is TOSNET's debt a risk? It doesn't seem so to us. 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. To that end, you should learn about the 4 warning signs we've spotted with TOSNET (including 1 which is potentially serious) .

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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