Semba Tohka Industries (TYO:2916) Has A Pretty Healthy Balance Sheet

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Semba Tohka Industries Co., Ltd (TYO:2916) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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.

See our latest analysis for Semba Tohka Industries

What Is Semba Tohka Industries's Debt?

The chart below, which you can click on for greater detail, shows that Semba Tohka Industries had JP¥5.25b in debt in September 2020; about the same as the year before. On the flip side, it has JP¥3.40b in cash leading to net debt of about JP¥1.86b.

How Healthy Is Semba Tohka Industries' Balance Sheet?

We can see from the most recent balance sheet that Semba Tohka Industries had liabilities of JP¥7.74b falling due within a year, and liabilities of JP¥3.20b due beyond that. Offsetting these obligations, it had cash of JP¥3.40b as well as receivables valued at JP¥4.03b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by JP¥3.52b.

This deficit isn't so bad because Semba Tohka Industries is worth JP¥6.98b, and thus could probably raise enough capital to shore up 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.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Semba Tohka Industries's net debt is only 0.93 times its EBITDA. And its EBIT covers its interest expense a whopping 60.9 times over. So we're pretty relaxed about its super-conservative use of debt. The good news is that Semba Tohka Industries has increased its EBIT by 9.9% over twelve months, which should ease any concerns about debt repayment. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Semba Tohka Industries 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Semba Tohka Industries created free cash flow amounting to 18% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

On our analysis Semba Tohka Industries's interest cover should signal that it won't have too much trouble with its debt. However, our other observations weren't so heartening. For instance it seems like it has to struggle a bit to convert EBIT to free cash flow. When we consider all the factors mentioned above, we do feel a bit cautious about Semba Tohka Industries's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example - Semba Tohka Industries has 4 warning signs we think you should be aware of.

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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