Kotobukiya (TYO:7809) Seems To Use Debt Rather Sparingly

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. Importantly, Kotobukiya Co., Ltd. (TYO:7809) does carry debt. But should shareholders be worried about its use of debt?

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 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. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Kotobukiya

What Is Kotobukiya's Debt?

As you can see below, at the end of December 2020, Kotobukiya had JP¥3.70b of debt, up from JP¥3.54b a year ago. Click the image for more detail. However, it does have JP¥2.02b in cash offsetting this, leading to net debt of about JP¥1.68b.

How Strong Is Kotobukiya's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Kotobukiya had liabilities of JP¥1.55b due within 12 months and liabilities of JP¥3.46b due beyond that. Offsetting these obligations, it had cash of JP¥2.02b as well as receivables valued at JP¥821.0m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by JP¥2.16b.

Kotobukiya has a market capitalization of JP¥5.88b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Kotobukiya's net debt is only 1.2 times its EBITDA. And its EBIT easily covers its interest expense, being 20.5 times the size. So we're pretty relaxed about its super-conservative use of debt. Even more impressive was the fact that Kotobukiya grew its EBIT by 380% over twelve months. If maintained that growth will make the debt even more manageable in the years ahead. When analysing debt levels, the balance sheet is the obvious place to start. But it is Kotobukiya'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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Kotobukiya actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

Kotobukiya's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And that's just the beginning of the good news since its conversion of EBIT to free cash flow is also very heartening. Looking at the bigger picture, we think Kotobukiya's use of debt seems quite reasonable and we're not concerned about it. After all, sensible leverage can boost returns on equity. 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. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for Kotobukiya (of which 1 is potentially serious!) you should know about.

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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