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.' 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. We note that Sekisui House, Ltd. (TSE:1928) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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 step when considering a company's debt levels is to consider its cash and debt together.
See our latest analysis for Sekisui House
What Is Sekisui House's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of April 2024 Sekisui House had JP„1.75t of debt, an increase on JP„654.4b, over one year. However, because it has a cash reserve of JP„400.3b, its net debt is less, at about JP„1.35t.
A Look At Sekisui House's Liabilities
The latest balance sheet data shows that Sekisui House had liabilities of JP„1.96t due within a year, and liabilities of JP„664.7b falling due after that. Offsetting these obligations, it had cash of JP„400.3b as well as receivables valued at JP„172.1b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by JP„2.05t.
This deficit is considerable relative to its very significant market capitalization of JP„2.27t, so it does suggest shareholders should keep an eye on Sekisui House's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.
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).
Sekisui House's net debt is 4.3 times its EBITDA, which is a significant but still reasonable amount of leverage. However, its interest coverage of 30.7 is very high, suggesting that the interest expense on the debt is currently quite low. Also relevant is that Sekisui House has grown its EBIT by a very respectable 25% in the last year, thus enhancing its ability to pay down debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Sekisui House can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Considering the last three years, Sekisui House actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.
Our View
We feel some trepidation about Sekisui House's difficulty conversion of EBIT to free cash flow, but we've got positives to focus on, too. To wit both its interest cover and EBIT growth rate were encouraging signs. Taking the abovementioned factors together we do think Sekisui House's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example Sekisui House has 2 warning signs (and 1 which is potentially serious) we think you should know about.
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. 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.
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com
About TSE:1928
Sekisui House
Designs, constructs, and contracts built-to-order detached houses in Japan and internationally.
Undervalued with solid track record and pays a dividend.
