Is Misumi (FKSE:7441) A Risky Investment?

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.' 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, Misumi Co., Ltd. (FKSE:7441) does carry debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Misumi

What Is Misumi's Debt?

You can click the graphic below for the historical numbers, but it shows that Misumi had JP¥10.9b of debt in September 2020, down from JP¥13.1b, one year before. On the flip side, it has JP¥5.40b in cash leading to net debt of about JP¥5.51b.

How Strong Is Misumi's Balance Sheet?

We can see from the most recent balance sheet that Misumi had liabilities of JP¥10.2b falling due within a year, and liabilities of JP¥5.90b due beyond that. On the other hand, it had cash of JP¥5.40b and JP¥3.16b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by JP¥7.51b.

This deficit is considerable relative to its market capitalization of JP¥10.4b, so it does suggest shareholders should keep an eye on Misumi's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Misumi's net debt is 2.6 times its EBITDA, which is a significant but still reasonable amount of leverage. However, its interest coverage of 1k is very high, suggesting that the interest expense on the debt is currently quite low. Importantly Misumi's EBIT was essentially flat over the last twelve months. We would prefer to see some earnings growth, because that always helps diminish debt. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Misumi 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 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. Over the most recent three years, Misumi recorded free cash flow worth 50% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Misumi's level of total liabilities and net debt to EBITDA definitely weigh on it, in our esteem. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. We think that Misumi's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Consider risks, for instance. Every company has them, and we've spotted 3 warning signs for Misumi 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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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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