AIAI Group (TSE:6557) Has A Somewhat Strained Balance Sheet

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, AIAI Group Corporation (TSE:6557) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for AIAI Group

How Much Debt Does AIAI Group Carry?

You can click the graphic below for the historical numbers, but it shows that AIAI Group had JP¥7.50b of debt in December 2023, down from JP¥8.40b, one year before. However, it does have JP¥1.68b in cash offsetting this, leading to net debt of about JP¥5.82b.

A Look At AIAI Group's Liabilities

We can see from the most recent balance sheet that AIAI Group had liabilities of JP¥2.36b falling due within a year, and liabilities of JP¥7.38b due beyond that. Offsetting these obligations, it had cash of JP¥1.68b as well as receivables valued at JP¥1.06b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by JP¥7.00b.

This deficit casts a shadow over the JP¥4.42b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, AIAI Group would probably need a major re-capitalization if its creditors were to demand repayment.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

AIAI Group's debt is 4.3 times its EBITDA, and its EBIT cover its interest expense 6.9 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. We also note that AIAI Group improved its EBIT from a last year's loss to a positive JP¥474m. 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 AIAI Group 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, AIAI Group actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

We'd go so far as to say AIAI Group's level of total liabilities was disappointing. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Once we consider all the factors above, together, it seems to us that AIAI Group's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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. We've identified 4 warning signs with AIAI Group (at least 2 which make us uncomfortable) , and understanding them should be part of your investment process.

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. 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.