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.' 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 Shigematsu Works Co., Ltd. (TYO:7980) does have debt on its balance sheet. But is this debt a concern to shareholders?
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. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.
See our latest analysis for Shigematsu Works
What Is Shigematsu Works's Net Debt?
The image below, which you can click on for greater detail, shows that Shigematsu Works had debt of JP¥2.90b at the end of September 2020, a reduction from JP¥3.19b over a year. However, it also had JP¥1.29b in cash, and so its net debt is JP¥1.60b.
How Strong Is Shigematsu Works's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Shigematsu Works had liabilities of JP¥5.31b due within 12 months and liabilities of JP¥1.80b due beyond that. Offsetting these obligations, it had cash of JP¥1.29b as well as receivables valued at JP¥2.41b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by JP¥3.40b.
Shigematsu Works has a market capitalization of JP¥8.79b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its 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).
Shigematsu Works has a low debt to EBITDA ratio of only 1.3. And remarkably, despite having net debt, it actually received more in interest over the last twelve months than it had to pay. So there's no doubt this company can take on debt while staying cool as a cucumber. Even more impressive was the fact that Shigematsu Works grew its EBIT by 227% over twelve months. That boost will make it even easier to pay down debt going forward. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Shigematsu Works's earnings that will influence how the balance sheet holds up in the future. 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. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Shigematsu Works reported free cash flow worth 16% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.
Our View
The good news is that Shigematsu Works'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. All these things considered, it appears that Shigematsu Works can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 2 warning signs for Shigematsu Works you should be aware of.
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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About TSE:7980
Solid track record with excellent balance sheet.
