These 4 Measures Indicate That SMS (TSE:2175) Is Using Debt Safely

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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. Importantly, SMS Co., Ltd. (TSE:2175) does carry debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for SMS

What Is SMS's Net Debt?

The chart below, which you can click on for greater detail, shows that SMS had JP¥7.20b in debt in December 2024; about the same as the year before. But on the other hand it also has JP¥16.3b in cash, leading to a JP¥9.10b net cash position.

A Look At SMS' Liabilities

The latest balance sheet data shows that SMS had liabilities of JP¥23.5b due within a year, and liabilities of JP¥5.82b falling due after that. On the other hand, it had cash of JP¥16.3b and JP¥19.5b worth of receivables due within a year. So it can boast JP¥6.50b more liquid assets than total liabilities.

This surplus suggests that SMS has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that SMS has more cash than debt is arguably a good indication that it can manage its debt safely.

But the other side of the story is that SMS saw its EBIT decline by 3.7% over the last year. That sort of decline, if sustained, will obviously make debt harder to handle. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if SMS can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. While SMS has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. During the last three years, SMS generated free cash flow amounting to a very robust 81% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Summing Up

While it is always sensible to investigate a company's debt, in this case SMS has JP¥9.10b in net cash and a decent-looking balance sheet. And it impressed us with free cash flow of JP¥5.3b, being 81% of its EBIT. So we don't think SMS's use of debt is risky. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 1 warning sign with SMS , 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. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.