Is HOBLtd (TYO:1382) A Risky Investment?

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 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. We can see that HOB Co.,Ltd. (TYO:1382) does use debt in its business. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for HOBLtd

What Is HOBLtd's Debt?

As you can see below, HOBLtd had JP¥216.0m of debt at December 2020, down from JP¥279.0m a year prior. However, its balance sheet shows it holds JP¥416.0m in cash, so it actually has JP¥200.0m net cash.

A Look At HOBLtd's Liabilities

Zooming in on the latest balance sheet data, we can see that HOBLtd had liabilities of JP¥831.0m due within 12 months and liabilities of JP¥127.0m due beyond that. Offsetting this, it had JP¥416.0m in cash and JP¥756.0m in receivables that were due within 12 months. So it can boast JP¥214.0m more liquid assets than total liabilities.

This surplus liquidity suggests that HOBLtd's balance sheet could take a hit just as well as Homer Simpson's head can take a punch. With this in mind one could posit that its balance sheet means the company is able to handle some adversity. Simply put, the fact that HOBLtd has more cash than debt is arguably a good indication that it can manage its debt safely.

The modesty of its debt load may become crucial for HOBLtd if management cannot prevent a repeat of the 63% cut to EBIT over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since HOBLtd 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. HOBLtd may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Happily for any shareholders, HOBLtd actually produced more free cash flow than EBIT over the last two years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Summing up

While it is always sensible to investigate a company's debt, in this case HOBLtd has JP¥200.0m in net cash and a decent-looking balance sheet. And it impressed us with free cash flow of JP¥101m, being 466% of its EBIT. So is HOBLtd's debt a risk? It doesn't seem so to us. 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. We've identified 3 warning signs with HOBLtd (at least 1 which is concerning) , 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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