Is ChoushimaruLtd (TYO:3075) Using Too Much Debt?

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. We note that Choushimaru Co.,Ltd. (TYO:3075) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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 step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for ChoushimaruLtd

What Is ChoushimaruLtd's Net Debt?

The image below, which you can click on for greater detail, shows that at February 2021 ChoushimaruLtd had debt of JP¥3.97b, up from JP¥309.0m in one year. But on the other hand it also has JP¥9.91b in cash, leading to a JP¥5.94b net cash position.

How Healthy Is ChoushimaruLtd's Balance Sheet?

We can see from the most recent balance sheet that ChoushimaruLtd had liabilities of JP¥6.09b falling due within a year, and liabilities of JP¥378.0m due beyond that. On the other hand, it had cash of JP¥9.91b and JP¥471.0m worth of receivables due within a year. So it can boast JP¥3.92b more liquid assets than total liabilities.

This surplus suggests that ChoushimaruLtd is using debt in a way that is appears to be both safe and conservative. Due to its strong net asset position, it is not likely to face issues with its lenders. Succinctly put, ChoushimaruLtd boasts net cash, so it's fair to say it does not have a heavy debt load!

The modesty of its debt load may become crucial for ChoushimaruLtd if management cannot prevent a repeat of the 73% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since ChoushimaruLtd will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While ChoushimaruLtd 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. Considering the last three years, ChoushimaruLtd actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that ChoushimaruLtd has net cash of JP¥5.94b, as well as more liquid assets than liabilities. So we don't have any problem with ChoushimaruLtd's use of debt. 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. Be aware that ChoushimaruLtd is showing 2 warning signs in our investment analysis , you should know about...

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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