These 4 Measures Indicate That Kozosushi (TYO:9973) Is Using Debt Reasonably Well

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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. As with many other companies Kozosushi Co., LTD. (TYO:9973) makes use of debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Kozosushi

What Is Kozosushi's Net Debt?

As you can see below, Kozosushi had JP¥217.0m of debt at December 2020, down from JP¥301.0m a year prior. On the flip side, it has JP¥133.0m in cash leading to net debt of about JP¥84.0m.

How Strong Is Kozosushi's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Kozosushi had liabilities of JP¥919.0m due within 12 months and liabilities of JP¥463.0m due beyond that. Offsetting these obligations, it had cash of JP¥133.0m as well as receivables valued at JP¥385.0m due within 12 months. So it has liabilities totalling JP¥864.0m more than its cash and near-term receivables, combined.

Since publicly traded Kozosushi shares are worth a total of JP¥6.35b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. But either way, Kozosushi has virtually no net debt, so it's fair to say it does not have a heavy debt load!

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.

Kozosushi has a low net debt to EBITDA ratio of only 0.88. And its EBIT covers its interest expense a whopping 19.3 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. It was also good to see that despite losing money on the EBIT line last year, Kozosushi turned things around in the last 12 months, delivering and EBIT of JP¥58m. When analysing debt levels, the balance sheet is the obvious place to start. But it is Kozosushi'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Kozosushi saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Kozosushi's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered were considerably better. In particular, we are dazzled with its interest cover. Looking at all this data makes us feel a little cautious about Kozosushi's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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. These risks can be hard to spot. Every company has them, and we've spotted 5 warning signs for Kozosushi (of which 2 don't sit too well with us!) you should know about.

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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