These 4 Measures Indicate That Sekisui House (TSE:1928) Is Using Debt Extensively

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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 can see that Sekisui House, Ltd. (TSE:1928) does use debt in its business. 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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Sekisui House

What Is Sekisui House's Debt?

As you can see below, at the end of July 2024, Sekisui House had JP¥1.79t of debt, up from JP¥754.8b a year ago. Click the image for more detail. On the flip side, it has JP¥460.5b in cash leading to net debt of about JP¥1.33t.

How Strong Is Sekisui House's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Sekisui House had liabilities of JP¥1.86t due within 12 months and liabilities of JP¥857.9b due beyond that. Offsetting these obligations, it had cash of JP¥460.5b as well as receivables valued at JP¥176.4b due within 12 months. So it has liabilities totalling JP¥2.09t more than its cash and near-term receivables, combined.

This deficit is considerable relative to its very significant market capitalization of JP¥2.51t, 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.

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

Sekisui House's net debt is 4.0 times its EBITDA, which is a significant but still reasonable amount of leverage. However, its interest coverage of 21.7 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 27% in the last year, thus enhancing its ability to pay down debt. When analysing debt levels, the balance sheet is the obvious place to start. 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Sekisui House recorded negative free cash flow, in total. 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

While Sekisui House's conversion of EBIT to free cash flow has us nervous. For example, its interest cover and EBIT growth rate give us some confidence in its ability to manage its debt. Looking at all the angles mentioned above, it does seem to us that Sekisui House is a somewhat risky investment as a result of its debt. 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. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 2 warning signs for Sekisui House (1 is a bit unpleasant) you should be aware of.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.