These 4 Measures Indicate That H2O Retailing (TSE:8242) Is Using Debt Extensively

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. Importantly, H2O Retailing Corporation (TSE:8242) does carry debt. But the more important question is: how much risk is that debt creating?

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. 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.

See our latest analysis for H2O Retailing

What Is H2O Retailing's Net Debt?

You can click the graphic below for the historical numbers, but it shows that H2O Retailing had JP¥163.8b of debt in June 2024, down from JP¥179.1b, one year before. However, it also had JP¥48.5b in cash, and so its net debt is JP¥115.2b.

How Strong Is H2O Retailing's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that H2O Retailing had liabilities of JP¥190.7b due within 12 months and liabilities of JP¥221.1b due beyond that. Offsetting this, it had JP¥48.5b in cash and JP¥88.2b in receivables that were due within 12 months. So its liabilities total JP¥275.1b more than the combination of its cash and short-term receivables.

Given this deficit is actually higher than the company's market capitalization of JP¥221.3b, we think shareholders really should watch H2O Retailing's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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

We'd say that H2O Retailing's moderate net debt to EBITDA ratio ( being 2.2), indicates prudence when it comes to debt. And its commanding EBIT of 1k times its interest expense, implies the debt load is as light as a peacock feather. Importantly, H2O Retailing grew its EBIT by 98% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine H2O Retailing'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, 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, H2O Retailing reported free cash flow worth 12% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

While H2O Retailing's level of total liabilities 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 H2O Retailing 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. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. To that end, you should learn about the 2 warning signs we've spotted with H2O Retailing (including 1 which is a bit unpleasant) .

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.