Here's Why Sumitomo Forestry (TSE:1911) Has A Meaningful Debt Burden

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Sumitomo Forestry Co., Ltd. (TSE:1911) makes use of debt. But the real question is whether this debt is making the company risky.

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Sumitomo Forestry

What Is Sumitomo Forestry's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2023 Sumitomo Forestry had JP¥402.3b of debt, an increase on JP¥333.9b, over one year. However, it also had JP¥157.2b in cash, and so its net debt is JP¥245.0b.

A Look At Sumitomo Forestry's Liabilities

According to the last reported balance sheet, Sumitomo Forestry had liabilities of JP¥588.0b due within 12 months, and liabilities of JP¥401.4b due beyond 12 months. Offsetting this, it had JP¥157.2b in cash and JP¥323.5b in receivables that were due within 12 months. So its liabilities total JP¥508.7b more than the combination of its cash and short-term receivables.

Sumitomo Forestry has a market capitalization of JP¥992.1b, 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.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Sumitomo Forestry has a low net debt to EBITDA ratio of only 1.4. And its EBIT covers its interest expense a whopping 449 times over. So we're pretty relaxed about its super-conservative use of debt. On the other hand, Sumitomo Forestry saw its EBIT drop by 7.3% in the last twelve months. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Sumitomo Forestry's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

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. In the last three years, Sumitomo Forestry's free cash flow amounted to 43% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Neither Sumitomo Forestry's ability to grow its EBIT nor its level of total liabilities gave us confidence in its ability to take on more debt. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. We think that Sumitomo Forestry's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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 2 warning signs with Sumitomo Forestry , 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.