These 4 Measures Indicate That Akikawa Foods & Farms (TYO:1380) Is Using Debt Reasonably Well

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 can see that Akikawa Foods & Farms Co., Ltd. (TYO:1380) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt A Problem?

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. If things get really bad, the lenders can take control of the business. 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. 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. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Akikawa Foods & Farms

What Is Akikawa Foods & Farms's Net Debt?

As you can see below, Akikawa Foods & Farms had JP¥2.17b of debt, at September 2020, which is about the same as the year before. You can click the chart for greater detail. However, because it has a cash reserve of JP¥830.0m, its net debt is less, at about JP¥1.34b.

How Strong Is Akikawa Foods & Farms' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Akikawa Foods & Farms had liabilities of JP¥1.94b due within 12 months and liabilities of JP¥1.46b due beyond that. Offsetting these obligations, it had cash of JP¥830.0m as well as receivables valued at JP¥842.0m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by JP¥1.73b.

Akikawa Foods & Farms has a market capitalization of JP¥4.89b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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).

Akikawa Foods & Farms's net debt to EBITDA ratio of about 2.1 suggests only moderate use of debt. And its strong interest cover of 23.0 times, makes us even more comfortable. Notably, Akikawa Foods & Farms's EBIT launched higher than Elon Musk, gaining a whopping 187% on last year. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Akikawa Foods & Farms 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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Akikawa Foods & Farms produced sturdy free cash flow equating to 53% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Akikawa Foods & Farms's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And that's just the beginning of the good news since its EBIT growth rate is also very heartening. When we consider the range of factors above, it looks like Akikawa Foods & Farms is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. 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. Consider for instance, the ever-present spectre of investment risk. We've identified 2 warning signs with Akikawa Foods & Farms , 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. 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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