Health Check: How Prudently Does HigashimaruLtd (FKSE:2058) Use Debt?

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 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 note that Higashimaru Co.,Ltd. (FKSE:2058) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. 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 HigashimaruLtd

What Is HigashimaruLtd's Net Debt?

You can click the graphic below for the historical numbers, but it shows that HigashimaruLtd had JP¥5.66b of debt in December 2020, down from JP¥6.06b, one year before. On the flip side, it has JP¥2.12b in cash leading to net debt of about JP¥3.55b.

How Healthy Is HigashimaruLtd's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that HigashimaruLtd had liabilities of JP¥6.40b due within 12 months and liabilities of JP¥1.83b due beyond that. On the other hand, it had cash of JP¥2.12b and JP¥2.84b worth of receivables due within a year. So its liabilities total JP¥3.27b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of JP¥3.48b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since HigashimaruLtd 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.

Over 12 months, HigashimaruLtd saw its revenue hold pretty steady, and it did not report positive earnings before interest and tax. While that's not too bad, we'd prefer see growth.

Caveat Emptor

Over the last twelve months HigashimaruLtd produced an earnings before interest and tax (EBIT) loss. To be specific the EBIT loss came in at JP¥266m. Considering that alongside the liabilities mentioned above does not give us much confidence that company should be using so much debt. Quite frankly we think the balance sheet is far from match-fit, although it could be improved with time. For example, we would not want to see a repeat of last year's loss of JP¥591m. So in short it's a really risky stock. 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. To that end, you should learn about the 3 warning signs we've spotted with HigashimaruLtd (including 2 which are a bit unpleasant) .

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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