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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Sougou Shouken Co.,Ltd. (TYO:7850) makes use of debt. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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.
See our latest analysis for Sougou ShoukenLtd
How Much Debt Does Sougou ShoukenLtd Carry?
As you can see below, Sougou ShoukenLtd had JP¥8.15b of debt, at October 2020, which is about the same as the year before. You can click the chart for greater detail. However, because it has a cash reserve of JP¥1.70b, its net debt is less, at about JP¥6.45b.
How Strong Is Sougou ShoukenLtd's Balance Sheet?
We can see from the most recent balance sheet that Sougou ShoukenLtd had liabilities of JP¥8.59b falling due within a year, and liabilities of JP¥3.41b due beyond that. Offsetting these obligations, it had cash of JP¥1.70b as well as receivables valued at JP¥3.80b due within 12 months. So it has liabilities totalling JP¥6.51b more than its cash and near-term receivables, combined.
The deficiency here weighs heavily on the JP¥1.90b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. After all, Sougou ShoukenLtd would likely require a major re-capitalisation if it had to pay its creditors today. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Sougou ShoukenLtd 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.
Over 12 months, Sougou ShoukenLtd made a loss at the EBIT level, and saw its revenue drop to JP¥15b, which is a fall of 13%. We would much prefer see growth.
Caveat Emptor
While Sougou ShoukenLtd's falling revenue is about as heartwarming as a wet blanket, arguably its earnings before interest and tax (EBIT) loss is even less appealing. Indeed, it lost JP¥181m at the EBIT level. Combining this information with the significant liabilities we already touched on makes us very hesitant about this stock, to say the least. Of course, it may be able to improve its situation with a bit of luck and good execution. Nevertheless, we would not bet on it given that it vaporized JP¥437m in cash over the last twelve months, and it doesn't have much by way of liquid assets. So we consider this a high risk stock and we wouldn't be at all surprised if the company asks shareholders for money before long. 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. Consider for instance, the ever-present spectre of investment risk. We've identified 4 warning signs with Sougou ShoukenLtd (at least 2 which shouldn't be ignored) , and understanding them should be part of your investment process.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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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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About TSE:7850
Solid track record, good value and pays a dividend.
