Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. We note that Sun Messe Co., Ltd. (TYO:7883) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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. When we examine debt levels, we first consider both cash and debt levels, together.
See our latest analysis for Sun Messe
How Much Debt Does Sun Messe Carry?
As you can see below, Sun Messe had JP¥1.92b of debt, at December 2020, which is about the same as the year before. You can click the chart for greater detail. But on the other hand it also has JP¥2.62b in cash, leading to a JP¥704.0m net cash position.
How Healthy Is Sun Messe's Balance Sheet?
The latest balance sheet data shows that Sun Messe had liabilities of JP¥4.61b due within a year, and liabilities of JP¥3.40b falling due after that. Offsetting this, it had JP¥2.62b in cash and JP¥3.47b in receivables that were due within 12 months. So it has liabilities totalling JP¥1.92b more than its cash and near-term receivables, combined.
This deficit isn't so bad because Sun Messe is worth JP¥5.94b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. While it does have liabilities worth noting, Sun Messe also has more cash than debt, so we're pretty confident it can manage its debt safely.
Fortunately, Sun Messe grew its EBIT by 5.9% in the last year, making that debt load look even more manageable. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Sun Messe 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. Sun Messe 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. Happily for any shareholders, Sun Messe actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
Summing up
Although Sun Messe's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of JP¥704.0m. And it impressed us with free cash flow of JP¥369m, being 185% of its EBIT. So is Sun Messe'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 be aware of the 1 warning sign we've spotted with Sun Messe .
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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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:7883
Sun Messe
Operates as a communication service center for printing, publishing, digital media, videos, and events businesses in Japan.
Flawless balance sheet established dividend payer.
