Kato Sangyo (TSE:9869) Has A Pretty Healthy Balance Sheet

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 Kato Sangyo Co., Ltd. (TSE:9869) does use debt in its business. But should shareholders be worried about its use of debt?

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Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Kato Sangyo's Net Debt?

The image below, which you can click on for greater detail, shows that Kato Sangyo had debt of JP¥5.75b at the end of December 2024, a reduction from JP¥6.12b over a year. But it also has JP¥83.4b in cash to offset that, meaning it has JP¥77.6b net cash.

A Look At Kato Sangyo's Liabilities

According to the last reported balance sheet, Kato Sangyo had liabilities of JP¥314.8b due within 12 months, and liabilities of JP¥25.6b due beyond 12 months. Offsetting these obligations, it had cash of JP¥83.4b as well as receivables valued at JP¥213.5b due within 12 months. So it has liabilities totalling JP¥43.5b more than its cash and near-term receivables, combined.

Kato Sangyo has a market capitalization of JP¥156.1b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. While it does have liabilities worth noting, Kato Sangyo also has more cash than debt, so we're pretty confident it can manage its debt safely.

See our latest analysis for Kato Sangyo

But the other side of the story is that Kato Sangyo saw its EBIT decline by 3.3% over the last year. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. When analysing debt levels, the balance sheet is the obvious place to start. But it is Kato Sangyo'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 business needs free cash flow to pay off debt; accounting profits just don't cut it. While Kato Sangyo has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. In the last three years, Kato Sangyo's free cash flow amounted to 48% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Summing Up

While Kato Sangyo does have more liabilities than liquid assets, it also has net cash of JP¥77.6b. So we are not troubled with Kato Sangyo's debt use. 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 - Kato Sangyo has 1 warning sign we think you should be aware of.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.