Is Ichishin HoldingsLtd (TYO:4645) Using Too Much Debt?

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.' 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. Importantly, Ichishin Holdings Co.,Ltd. (TYO:4645) does carry debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Ichishin HoldingsLtd

What Is Ichishin HoldingsLtd's Debt?

As you can see below, at the end of November 2020, Ichishin HoldingsLtd had JP¥5.57b of debt, up from JP¥4.11b a year ago. Click the image for more detail. However, because it has a cash reserve of JP¥2.83b, its net debt is less, at about JP¥2.74b.

How Healthy Is Ichishin HoldingsLtd's Balance Sheet?

According to the last reported balance sheet, Ichishin HoldingsLtd had liabilities of JP¥3.71b due within 12 months, and liabilities of JP¥6.98b due beyond 12 months. On the other hand, it had cash of JP¥2.83b and JP¥331.0m worth of receivables due within a year. So its liabilities total JP¥7.53b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the JP¥3.52b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. After all, Ichishin HoldingsLtd would likely require a major re-capitalisation if it had to pay its creditors today.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Ichishin HoldingsLtd has net debt worth 2.3 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 5.6 times the interest expense. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. Pleasingly, Ichishin HoldingsLtd is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 158% gain in the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Ichishin HoldingsLtd 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.

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. Considering the last three years, Ichishin HoldingsLtd actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

Mulling over Ichishin HoldingsLtd's attempt at staying on top of its total liabilities, we're certainly not enthusiastic. But at least it's pretty decent at growing its EBIT; that's encouraging. Looking at the bigger picture, it seems clear to us that Ichishin HoldingsLtd's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. 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 3 warning signs we've spotted with Ichishin HoldingsLtd (including 1 which doesn't sit too well with us) .

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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This article by Simply Wall St is general in nature. 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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