Is Makoto Construction CoLtd (TSE:8995) Using Too Much Debt?

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. We can see that Makoto Construction Co,Ltd (TSE:8995) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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 Makoto Construction CoLtd

What Is Makoto Construction CoLtd's Net Debt?

The image below, which you can click on for greater detail, shows that at March 2024 Makoto Construction CoLtd had debt of JP¥1.46b, up from JP¥1.22b in one year. On the flip side, it has JP¥1.39b in cash leading to net debt of about JP¥71.0m.

A Look At Makoto Construction CoLtd's Liabilities

According to the last reported balance sheet, Makoto Construction CoLtd had liabilities of JP¥801.0m due within 12 months, and liabilities of JP¥1.26b due beyond 12 months. On the other hand, it had cash of JP¥1.39b and JP¥69.0m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by JP¥599.0m.

While this might seem like a lot, it is not so bad since Makoto Construction CoLtd has a market capitalization of JP¥1.41b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).

Makoto Construction CoLtd has a low debt to EBITDA ratio of only 0.38. But the really cool thing is that it actually managed to receive more interest than it paid, over the last year. So it's fair to say it can handle debt like a hotshot teppanyaki chef handles cooking. In fact Makoto Construction CoLtd's saving grace is its low debt levels, because its EBIT has tanked 44% in the last twelve months. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. There's no doubt that we learn most about debt from the balance sheet. But it is Makoto Construction CoLtd'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 company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Makoto Construction CoLtd reported free cash flow worth 17% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

We feel some trepidation about Makoto Construction CoLtd's difficulty EBIT growth rate, but we've got positives to focus on, too. To wit both its interest cover and net debt to EBITDA were encouraging signs. Taking the abovementioned factors together we do think Makoto Construction CoLtd's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. For instance, we've identified 3 warning signs for Makoto Construction CoLtd (1 is potentially serious) you should be aware of.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.

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