Here's Why S.IshimitsuLtd (TYO:2750) Can Manage Its Debt Responsibly

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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies S.Ishimitsu & Co.,Ltd. (TYO:2750) makes use of debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for S.IshimitsuLtd

What Is S.IshimitsuLtd's Net Debt?

The chart below, which you can click on for greater detail, shows that S.IshimitsuLtd had JP¥6.89b in debt in September 2020; about the same as the year before. However, it also had JP¥4.27b in cash, and so its net debt is JP¥2.62b.

How Healthy Is S.IshimitsuLtd's Balance Sheet?

We can see from the most recent balance sheet that S.IshimitsuLtd had liabilities of JP¥9.49b falling due within a year, and liabilities of JP¥4.94b due beyond that. Offsetting this, it had JP¥4.27b in cash and JP¥7.94b in receivables that were due within 12 months. So its liabilities total JP¥2.22b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of JP¥3.15b. 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.

S.IshimitsuLtd has net debt to EBITDA of 3.0 suggesting it uses a fair bit of leverage to boost returns. On the plus side, its EBIT was 8.9 times its interest expense, and its net debt to EBITDA, was quite high, at 3.0. Importantly S.IshimitsuLtd's EBIT was essentially flat over the last twelve months. We would prefer to see some earnings growth, because that always helps diminish debt. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since S.IshimitsuLtd will need earnings to service that debt. 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 always check how much of that EBIT is translated into free cash flow. Over the last three years, S.IshimitsuLtd actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

When it comes to the balance sheet, the standout positive for S.IshimitsuLtd was the fact that it seems able to convert EBIT to free cash flow confidently. But the other factors we noted above weren't so encouraging. For instance it seems like it has to struggle a bit to handle its total liabilities. When we consider all the factors mentioned above, we do feel a bit cautious about S.IshimitsuLtd's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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. To that end, you should learn about the 4 warning signs we've spotted with S.IshimitsuLtd (including 1 which is can't be ignored) .

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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