We Think Ichishin HoldingsLtd (TYO:4645) Is Taking Some Risk With Its Debt

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.' 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 can see that Ichishin Holdings Co.,Ltd. (TYO:4645) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Ichishin HoldingsLtd

What Is Ichishin HoldingsLtd's Debt?

The image below, which you can click on for greater detail, shows that at August 2020 Ichishin HoldingsLtd had debt of JP¥5.20b, up from JP¥4.17b in one year. On the flip side, it has JP¥2.49b in cash leading to net debt of about JP¥2.70b.

A Look At Ichishin HoldingsLtd's Liabilities

We can see from the most recent balance sheet that Ichishin HoldingsLtd had liabilities of JP¥3.54b falling due within a year, and liabilities of JP¥6.82b due beyond that. Offsetting this, it had JP¥2.49b in cash and JP¥330.0m in receivables that were due within 12 months. So its liabilities total JP¥7.54b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the JP¥3.41b 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 definitely think shareholders need to watch this one closely. At the end of the day, Ichishin HoldingsLtd would probably need a major re-capitalization if its creditors were to demand repayment.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Ichishin HoldingsLtd has a debt to EBITDA ratio of 2.6 and its EBIT covered its interest expense 4.1 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Importantly, Ichishin HoldingsLtd grew its EBIT by 58% over the last twelve months, and that growth will make it easier to handle its debt. 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 Ichishin HoldingsLtd 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Ichishin HoldingsLtd barely recorded positive free cash flow, in total. Some might say that's a concern, when it comes considering how easily it would be for it to down debt.

Our View

We'd go so far as to say Ichishin HoldingsLtd's level of total liabilities was disappointing. 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. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Be aware that Ichishin HoldingsLtd 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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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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